When Was the Last Time You Examined Your 401(k) Plan’s Definition of Compensation?
Each year, around the beginning of summer it seems that I receive a call from a client whose 401(k) plan auditors have discovered an error with the compensation definition in their plan. A common scenario is that the plan has always provided that bonuses be included but the plan sponsor hasn’t been including some sort of bonus payment in plan compensation because they didn’t consider it to be a bonus. Another common scenario is that an exclusion that has always been in the plan was inadvertently dropped during a restatement of the plan, but the plan sponsor continued to operate the plan as if the exclusion was in place.
Regardless of why an error has happened or how innocent the error may seem, the IRS requires that plan sponsors follow the definition of compensation in their plans. If your plan says it uses W-2 compensation with no exclusions, then you must make sure that you are applying an individual’s deferral election to all items that appear in box 1, including imputed items of compensation such as life insurance benefits in excess of $50,000. Failing to follow the plan’s definition of compensation can be a costly mistake for employers, especially if the error continue on for years.
For example, let’s say ABC Company had not been deferring on mid-year bonuses that it gives to its manager. Samantha receives a $5,000 bonus and has a deferral election in place of 10% of compensation. Let’s also assume that ABC Company matches on the first 4% of compensation. The correction for not including this bonus in compensation would be that ABC Company would have to make a contribution to the plan of $250, which is equal to 50% of Samantha’s missed deferral ($5,000*10%*50%). ABC Company would also have to make a contribution for the entire missed matching contribution, which in this case would be $200. Both amounts must be adjusted for earnings. You can imagine that this could add up quickly if you had a large number of employees and the error occurred for multiple years.
Therefore, if you haven’t done an audit of your payroll lately to ensure that you are using the proper definition of compensation, now would be a great time. Also, make sure that you carefully review, or have your attorney carefully review, any plan amendments or restatements to ensure that items were not inadvertently changed. Taking a few minutes to do this now could save you thousands of dollars and lots of time down the road.