401(k) Fix It #3
Understanding the problem:
Because your plan may use different definitions of compensation for different purposes, it’s important to apply the proper definition for deferrals, allocations and testing. A plan’s compensation definition must satisfy rules for determining the amount of contributions. One of those rules is that the amount of compensation considered under the plan can’t exceed $290,000 in 2021 ($285,000 in 2020 subject to cost-of-living adjustments for later years). This limit is described in IRC Section 401(a)(17).
You must follow the plan document compensation definitions. Compensation generally includes the pay a participant received from the employer for personal services for a year including:
- Wages and salaries
- Fees for professional services
- Other amounts received (cash or non-cash) for personal services actually rendered by an employee, including, but not limited to:
- Commissions and tips
- Fringe benefits
- Bonuses
The Plan’s terms may include all or a portion of compensation for purposes of determining an employee’s allocation or salary reduction contribution. In addition, your plan may need to ensure that compensation used for testing complies with applicable statutes. For example, a plan might preclude employees from making deferrals from overtime income. However, if overtime is primarily paid to non-highly compensated employees, then the plan may not be able to use the plan’s restricted definition of compensation for the actual deferral percentage (ADP) test. The plan would have to ensure that the definition of compensation complies with the requirements of IRC Section 414(s) and may need to include overtime for this purpose. Thus, it’s critical that the plan monitor its operation to ensure that the terms of the plan are followed to determine an employee’s elective deferral or other allocation. In addition, it’s critical to monitor the plan to ensure that the compensation used for different testing purposes (e.g., ADP, section 415, top heavy) comply with applicable statutes.
How to find the problem:
Review the plan document to determine if you're using the proper compensation for allocations, deferrals and testing. Many plan sponsors operate their plan based on a plan summary of the definitions and operational requirements. As the plan is amended, the compensation definition may change while the plan continues to operate as it had previously.
Review the plan sections dealing with allocations and deferrals. Each plan contains sections, either in the plan document or in an adoption agreement, that discuss how the plan must make allocations and deferrals. This section may say, for example, “Employees may defer up to 15% of their Compensation…” You then have to go to the plan section containing definitions and find the “Compensation” definition. Spot-check deferrals and allocations to see if you're using the correct compensation. Some of these definitions can get complicated with expense reimbursements, car allowances, bonuses, commissions and overtime pay that is or is not included in the definition of compensation. If you have a plan with a complicated definition of compensation, you may want to develop a worksheet to calculate the correct amounts.
How to fix the problem:
Corrective action:
There are a couple of ways to make corrections when you have improperly allocated amounts because you didn’t follow the plan definition of compensation. If you've determined that an employee made excess elective deferrals, give the participant a distribution of the excess deferrals plus earnings. However, if net earnings are negative then, the plan sponsor will need to make an additional contribution to the participant’s account to reimburse it for the loss. In addition, matching contributions related to the excess deferral (adjusted for earnings) should be forfeited and based on plan terms, either reallocated to other participants or to an unallocated account to be used for future matching contributions. If there are improper profit-sharing contributions, forfeit and based on plan terms reallocate the contributions plus earnings to plan participants or to an unallocated account to be used to be used for future profit sharing contributions.
If you’ve determined that an employee made deferrals that were less than what should have been made had the correct compensation amount been used, then a corrective contribution needs to be made to the employee’s account within the plan. The employee would receive a corrective qualified non-elective contribution (which is an employer contribution in which the employee is fully vested) equal to 50% of the missed deferral (i.e., the difference between the amount that should have been deferred based on the use of correct compensation and what was deferred). In addition, the employee would receive a corrective employer matching contribution, if applicable, equal to the difference between what the employee would have received if the correct elective deferral was made and the actual matching contribution. Finally, the employee would receive a corrective employer contribution to the extent that he or she received a profit sharing allocation that was less than what he or she would have been entitled to had the correct compensation been used. All corrective contributions must be adjusted for earnings.
For failures found and fixed promptly, plan sponsors have the option to reduce the corrective contribution for the lost opportunity cost from 50% of the missed deferral to 25% under certain conditions. For additional details, see Problem #6 of the 401(k) Fix-it Guide.
How to avoid the problem:
- Perform annual reviews of the plan operations.
- If the plan document is amended, check the definitions against the old document, noting any differences. Have a centralized person or department responsible for maintaining all plan documents.
- If you amend your plan document, communicate those changes to everyone involved in the plan’s operation. Plan sponsors should develop an internal communication mechanism to timely and accurately advise plan administrators and outside service providers (outside plan consultant, actuary and/or third party administrator/record keeper) of changes.
- Provide proper training of in-house personnel who determine compensation to understand the plan document.
- Know what your third party administrators have agreed to provide. They may be relying on you for information, such as compensation and deferral amounts used in their work. Retain a copy of your third party administrator service contract including any updated contracts; and keep a summary of what’s being supplied to the plan by the third party administrator, actuary or consultant. Keep this service contract and summary with the person responsible for maintaining all plan documents.
- Try to simplify your plan’s definition of compensation and use the same definition for multiple purposes.
Content Library:
Fix It #1: You haven't updated your plan within the last few years to reflect recent law changes.
Fix It #2: You didn't base the plan operations on the terms of the plan document.
Fix It #4: Employer matching contributions weren't made to all appropriate employees.