Originally published in Volume 33 of the Journal of Accountancy.
Abstract
Errors in applying the correct definition of compensation are among the most common issues uncovered during 401(k) plan audits. The plan document dictates what counts as compensation for contributions and compliance testing and misunderstanding this can lead to costly corrections and regulatory exposure. This article explains what “definition of compensation” means, how to identify and interpret your company’s definition within the plan document, and practical steps to take when discrepancies arise. By understanding these nuances and implementing preventive measures, organizations can reduce risk and maintain compliance.
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After years of auditing employee benefit plans, one error continues to top the list: failure to follow the plan document’s definition of compensation. In our practice, we see this occurring in all different types of our client base: new plans that have never been audited, new plans to us that have been audited by predecessor audit firms, and even in long-time clients that we have audited for several years. While it might seem straightforward, the definition of compensation is one of the hardest areas of a benefit plan to understand. In a defined contribution 401(k) plan, compensation drives everything. It is the core of the contribution calculations, census data used for nondiscrimination testing, and overall plan compliance. When the definition of compensation is not applied correctly, this can lead to costly errors and corrective actions that need to be taken by a company. Understanding and applying the definition correctly is essential for avoiding these pitfalls.
Let’s start at the beginning – the plan document. Every 401(k) plan has a plan document. The plan document is the legal document that governs how the plan operates. It serves as the blueprint of the plan and the roadmap of how to govern a plan. A plan must be administered according to the plan provisions as stated and defined in the plan document. This document serves as the ultimate authority. Payroll systems, human resource policies, and administrative policies and controls must align with it. If there is a discrepancy or conflict in any of these areas, the plan document will always win. One of the main provisions stated in a plan document is compensation. We always recommend to clients to make sure that they have the most updated version of the plan document easily accessible. This is even more important if the plan has been amended and there are multiple versions over the years. Typically, in a plan document, there is an entire section dedicated to compensation. In this section it will define the base compensation that should be used for purposes of the 401(k) plan. Examples of this could be W-2 wages, Code Section 3401(a) wages, or Code Section 415 definition of compensation. After the base is defined and explained, there is usually a section that describes any additional alterations or exclusions from the base compensation. Examples of these are items like: overtime pay, bonuses, commissions, expense allowances or reimbursements, fringe benefits, or stock options. It is important to remember that every plan is unique. Qualified plans that have the same pre-approved plan document from their service provider don’t all have the same definition of compensation. This is tailored for every plan in accordance with how the company would like to operate their plan. While it is important to understand the base definition, I would argue that it is even more important to understand the alterations or exclusions in compensation as this is where we start to see problems.
We will now look at some of the most common pitfalls that we see in auditing 401(k) plans as it relates to compensation.
- Using gross wages instead of plan-defined compensation – this is a very common occurrence that is seen in audits of 401(k) plans. In this case, only the gross pay is used by the plan sponsor in actual operation, and no adjustments have been made at all based on how compensation is defined in the plan document.
- Excluding bonuses, overtime or commission pay in eligible compensation – In this case, compensation that should have been included for participant deferrals pursuant to the plan document has been excluded in administration. Therefore, employee contributions are being calculated on a lower amount of compensation. For example, if a participant received a $10,000 bonus and has elected 10% deferrals, they should have deferred $1,000 of employee contributions into the plan. If this did not occur, their plan balance is too low. This also would affect any employer match, if applicable. The matching contributions would be too low since a lower compensation base was used as the starting point. In this case, the participant is due additional money for missed deferrals and possibly match. This amount is then funded by the company/plan sponsor, adjusted for earnings.
- Including bonuses, overtime or commission pay in eligible compensation – This is the opposite of the scenario above. In some cases, pay types like bonuses, overtime, or commission are included in eligible compensation in operation when they should not be. In these instances, a participant’s plan account balance is overstated. The plan sponsor contributed too much of the participant’s pay and the participant could have potentially received too much of a matching contribution to their account. Here, amounts could have to be refunded to the participant and employer match amounts would have to be forfeited from the participant’s account.
- Not updating payroll systems timely when there is an amendment to the plan document – if a plan has been amended and one of the amendments is related to compensation, it is imperative that the plan administrator of the plan at the company ensure that any changes to compensation are made in the payroll system. It could be that a plan since inception has included bonus pay in their definition of eligible compensation. A company may decide now to exclude that type of pay, and it needs to be reflected in payroll.
- Not updating the payroll system when a new payroll code is added – this has been a relatively new error we have seen in the past few years. Companies may introduce new payroll codes such as hazard pay, special bonus pay, holiday bonus, etc. during the year and they are shown in the payroll system. These codes need to be reviewed against the definition of compensation to see if they should be included or excluded from 401(k) eligible compensation. We see that with new codes they should be either included or excluded, however the switch to turn these on in payroll never happened.
In all of the above examples, there would be an error in how the definition of compensation was applied for 401(k) purposes. Now that we have identified how compensation could be applied incorrectly, we will now focus on what to do next. The first step in this is understanding and accepting that there is an error and then moving forward on corrective actions. The following steps should be followed after identifying that there is a problem.
- Identify the scope – There are two questions that need to be addressed when identifying the scope of the compensation issue. The first is – how long has this error been occurring? The second is – which employees are affected? As described above in the pitfalls section, you may identify one person that didn’t properly withhold 401(k) deferrals on bonus pay. The first step is figuring out the magnitude of the issue. Did this happen to just this one participant? Or did it happen to the entire population of participants in the Plan? Also, did it just occur in one calendar year or has it been an issue for several years?
- Calculate the impact – The impact of an error in the definition of compensation is seen mainly from a monetary perspective. If a plan has performed non-discrimination testing using the wrong compensation data, that would have to be redone with the correct data. If the plan doesn’t pass the testing in some areas with the new data, there are usually monetary corrections that need to be made. The bigger monetary area for the plan is in the missed contributions or overfunded contributions. Calculating what affected participants should have received from an employee and employer contribution standpoint or what they shouldn’t receive and have to return takes a lot of time and diligence, especially if the impact is to multiple employees over several years. The corrections are typically 50% of missed employee deferrals (but can be 25% in some instances) and then 100% of the missed employer matching contributions. When a definition of compensation error is identified, best practice is to correct it back to the earliest year it occurred. However, this isn’t always practical – records may be incomplete, payroll systems may have changed, or historical data may be unavailable. In those cases, the recommended approach is to correct as many years as possible to minimize compliance risk.
- Notify the affected participants – Once you have determined the scope and the impact to the plan and participants, it is best to notify those participants. The communication should be sent to all affected participants describing the issue and the impact on their account balance. This should be done in all cases – whether they should be receiving more money or if they already received too much money and will need to forfeit the overage amounts.
- Correct the error – The next step after you know the impact/amount of the error is to correct the error. This means you will need to either fund the plan with additional monies owed to the participants or take money out of the participants’ accounts and forfeit any employer matching contributions. This should be done as soon as administratively feasible after the impact has been determined. There are different methods of correction that can be used based on the severity of the issue: self-correction program, voluntary correction program, or the audit closing agreement program.
- Prevent recurrence – Once you have gone through a definition of compensation issue, I guarantee that you don’t want to have to deal with it again. It takes a substantial amount of time and effort by multiple parties to go through the steps outlined above. After you have an issue, it is best to examine your current process and controls to determine what needs to be changed to prevent this from happening again. If you decide to change process and controls, make sure that those are clearly documented and made available. You should also implement training for your benefits and payroll staff so that they are aware of what the definition of compensation means for the 401(k) plan and company. Lastly, reviewing the payroll system and plan document on a periodic basis is a best practice to ensure that nothing seems to be missing or incorrect in the payroll system setup as it compares to the plan document.
Using the wrong definition of compensation is one of the most common operational failures in defined contribution 401(k) plans. Understanding and correctly applying the definition of compensation isn’t just a technical detail – it’s a cornerstone of 401(k) plan compliance. Missteps in this area can lead to costly corrections, failed testing, and regulatory exposure. Companies should treat this as an ongoing process; not a one-time setup. Regular reviews of the plan document, clear communication between payroll and human resources, and proactive training can help ensure that compensation is calculated accurately and consistently. By not taking action and addressing these concerns, any errors in a qualified plan could lead to a plan becoming a disqualified under the Internal Revenue Code and losing its tax-exempt status. In making this a priority, organizations can protect both their employees’ retirement savings and their own compliance standing.
Reach out to Anne Morris or your Windham Brannon Advisor today.
