Author: Erin Books
ERISA Consulting Lead
One of the most common plan failures we see is the use of the wrong definition of compensation for plan contributions. A failure like this can be expensive to fix, but also easy to avoid. This article will address options to fix the plan, as well as ways to avoid this issue.
The definition of compensation isn’t the easiest part of the plan document to read. However, it is certainly important to understand. If a participant elects to contribute three percent of his pay each pay period, then three percent needs to be contributed based on the plan’s compensation definition. Not only does the person signing the plan document need to understand the definition, but so does the employer’s payroll team or provider. If there is a disconnect between these groups, the wrong definition may be applied.
For example, employees may receive taxable fringe benefits, like insurance or a gift card, that are not really “paid” to them. They don’t receive these amounts in their pay check, but generally, they are included in the plan’s definition of compensation. If these amounts aren’t factored into the calculation, the result will be a reduced and incorrect contribution.
Although less common, some errors result in employees receiving larger contributions than they should. For example, if the plan document says bonuses are excluded from compensation, but this isn’t applied when calculating contributions, employees will receive a greater contribution than they are entitled to.
With operational failures like this, there are two options to correct the plan. First, the contributions can be adjusted to reflect what they should have been according to the document. Second, the plan document can be amended retroactively to match the plan’s operations.
The first approach includes recalculating all plan contributions, including any missed deferral opportunities, to determine if the participant received too little or too much. If the participant received too little, the employer makes a corrective contribution. If the participant received too much, a distribution or forfeiture will be required. Any corrective contributions or distributions are also adjusted for earnings or loss to fully correct the plan. If a large amount of pay wasn’t included properly over time, this can get expensive quickly!
Correcting contribution amounts can be done through self-correction if the failure is insignificant or occurred in the last two years. Otherwise, the employer can propose a correction method under the IRS’ voluntary correction program (VCP). This can also be costly, as the VCP filing fee ranges from $1,500 to $3,500, based on plan asset size. In addition, the employer will want to engage the services of a consultant or ERISA attorney to prepare the filing.
The second approach is to retroactively amend the plan document to match the plan’s operations. This approach avoids the need to make corrective contributions or process corrective distributions from the plan. If the correction is in the employee’s favor, this can likely be handled through self-correction. This is a new option due to the IRS’ Revenue Procedure 2019-19, which expanded the self-correction opportunities for employers. For example, if the plan document excluded compensation paid before an employee enters the plan, but in operation this pay was included, retroactively amending the plan will provide a greater benefit to employees.
Alternatively, if the correction to the document means employees will not receive the same benefit they would have otherwise been entitled to, the IRS will need to review and approve the fix through the VCP. In this case, the IRS will look to the employer to prove that the retroactive amendment matches their intent, as well as their employees’ expectations. If this can be done, the IRS may approve this correction, but there are no guarantees.
The IRS’ 401(k) Plan Fix-It Guide addresses this type of mistake. It advises plan administrators to perform an annual review of their plan’s compensation definition. In addition, plan administrators should ensure the person determining compensation for plan contribution purposes is trained to understand the document. I would take this a step further and have them verify that their payroll team or provider is applying the right codes in their software so that the correct definition is applied for deferral elections and any other calculations performed by the system.
The employer has flexibility in choosing their plan’s definition of compensation. Two things should be considered when determining the definition: the ease of administration and the cost of providing employer contributions. If taxable fringe benefits or cash bonuses are not easily factored into deferral elections, perhaps they should be excluded. If a participant’s final pay check includes both regular pay and post-severance leave pay, perhaps the post-severance pay should be included. Keep in mind that some definitions of compensation may prove to be discriminatory, so be sure to discuss this with your third-party administrator before implementing a change in your plan.
Last, but certainly not least, Goldleaf Partners offers payroll services that fully integrate with our retirement plan administration services. By integrating these two services with us, we can ensure the payroll system is set-up to match the plan’s document and all contributions are calculated using the correct compensation definition. That’s one less thing for employers to worry about!
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