Compensation errors are one of the most common plan administration related errors that the Department of Labor (DOL) and the Internal Revenue Service (IRS) find when auditing qualified retirement plans. One of the best ways to avoid compensation errors is to first truly understand what your plan’s definition of compensation actually provides. Understanding the basics is crucial because if you don’t know how your plan defines compensation, the risk of errors in operating the plan is sure to increase.
So, how exactly does your plan document define compensation? Is it clearly defined as “Code § 3401(a)”? “W-2 wages”? “415 simplified compensation”? Or is it more detailed than that, specifically detailing what is to be included/excluded in a long, difficult-to-decipher definition? If it’s the latter and you’re not entirely sure what your definition of compensation entails, be sure to seek guidance on the matter.
For purposes of this blog, we’ll keep it simple and go over the three basic kinds of compensation definitions used in plans as well as provide a chart that will serve as a useful guide in determining what should be included for purposes of your definition. Plan sponsors can choose from one of three safe-harbor definitions for IRC §§ 415 and 414(s)/non-discrimination purposes. These three safe harbors are as follows:
– Code §3401(a)1: This definition is the amount of compensation subject to tax withholding.
– W-2 Wages (Code §§ 6041, 6051 and 6052 Compensation)2: In this definition, W-2 wages are calculated for the year and include the additional amounts of compensation, if any, that do not have income tax withheld. So, all compensation included in 3401(a) wages would also be included in W-2 wages; however, because certain income is exempt from income tax withholding, not all W-2 wages should be included in 3401(a) wages.
– 415 Simplified Compensation3: This is a simplified definition of compensation; it only includes wages, fees for professional services, and amounts received for personal services to the extent that those amounts are includible in gross income.
With these basic definitions and not much more, it’s still quite difficult to understand the differences among these safe harbor definitions of compensation. To better explain the differences—at least with respect to what you should be including in your plan’s definition—use the following chart as a guide:
|Compensation Item||Code §3401(a) Compensation||W-2 Wages Compensation||415 Simplified Compensation|
|Received from unfunded nonqualified plan||Include||Include||Exclude|
|Tips||Generally include. Exclude noncash and tips < $20/month||Include|
|Fringe Benefits (includible in income)||Typically include (except those specifically excluded by definition)||Include||Include|
|Accident & Health Plan (if taxable)||Generally include.Exclude self-insured medical||Include||Exclude|
|Moving Expenses Reimbursement||Exclude if deductible||Include (may modify to exclude without affecting safe harbor)||Exclude|
|Group Term Life Insurance (more than $50,000)||Exclude||Include||Include|
|Non-qualified stock option exercise||Include||Include||Exclude|
|Qualified stock option exercise||Exclude||Exclude||Exclude|
|Non-qualified option, when granted||Include||Include||Exclude|
This chart is a useful reference tool for the basics of compensation. For a more detailed look at compensation errors and how to avoid them, be sure to download our white paper . If you have any questions, please contact our ERISA Services team.