A common operational failure for retirement plans is when plan sponsors fail to apply the correct definition of compensation for retirement plan testing and benefit allocation purposes. Using an incorrect compensation total can impact the average deferral percentage (ADP) and actual contribution percentage (ACP) tests, leading to an inaccurate “pass”, or triggering a refund of excess deferral or contribution unnecessarily. It can also impact correct calculations of employee deferral, employer match, and profit-sharing amounts.
To ensure the correct compensation total is used, refer to your retirement plan document. It is important to note whether certain types of compensation are excluded for different plan purposes, limiting compensation with regards to statutory limits, and computing compensation based on the correct period. Some examples of compensation types are salary, overtime, bonus, commissions, and fringe benefits. It is important to note how each type of compensation is used for each plan purpose.
The IRS has a 401(k) Fix-It Guide along with suggestions for avoiding mistakes.
How To Avoid Retirement Plan Compensation Definition Mistakes
- Perform annual reviews of the retirement plan operations.
- If the retirement 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 retirement plan document, communicate those changes to everyone involved in the plan’s operation. Retirement 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 retirement plan 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 retirement plan’s definition of compensation and use the same definition for multiple purposes.
Seeking assistance with your company’s retirement plan documents and definition of compensation? Avoid miscalculations by connecting with the experienced retirement plan actuaries at Watkins Ross. Together we can review your retirement plan documents, perform annual retirement plan reviews and assessments, and ensure your retirement plan documents meet both IRS and organizational requirements.
