Using the correct definition of your compensation plan in your 401(k) plan is essential. When it’s wrong, it can cause headaches like failed plan tests, incorrect contributions, or even IRS penalties. Here’s what you need to know to avoid these issues.
What Happens When You Use the Wrong Compensation Plan Definitions?
If you’re not following the plan’s definition of compensation, you might run into problems like:
- Incorrect Plan Testing: Mistakes can lead to inaccurate results for Average Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. This could trigger unnecessary refunds or corrections.
- Wrong Contribution Calculations: Errors affect employee deferrals, employer matches, and profit-sharing amounts. Fixing these mistakes later can be costly.
How to Get It Right
Start by checking your plan document. It explains how different types of compensation such as salary, overtime, bonuses, and commissions are treated for testing, contributions, and other purposes. Be aware of:
- Excluded Compensation: Your plan might exclude certain types of pay, like bonuses or overtime.
- Statutory Limits: Compensation used for calculations must stay within IRS limits.
- Correct Timeframes: Ensure you’re using data from the right periods.
For more guidance, check out the IRS 401(k) Fix-It Guide.
Tips to Avoid Common Mistakes in Youre Compensation Plan
- Review the Plan Regularly: Understand the definition of compensation and ensure it aligns with plan operations.
- Verify Payroll Systems: Make sure your payroll system uses the correct compensation codes.
- Update After Plan Changes: If the plan document changes, compare the new and old definitions and communicate updates to everyone involved.
- Train Your Team: Teach in-house personnel how compensation is defined and used.
- Coordinate with Third-Party Administrators (TPAs): Know what your TPA needs from you, like compensation data and deferral amounts. Keep copies of contracts and summaries of their services.
- Simplify Where Possible: Use the same compensation definition for multiple purposes to reduce confusion.
Watch Out for IRS Limits
Every year, the IRS sets limits for:
- Maximum Deferrals: How much an employee can contribute.
- Catch-Up Contributions: Extra contributions allowed for participants age 50+.
- Compensation Limits: The maximum amount of compensation used to calculate contributions.
If these limits aren’t monitored, employees might contribute too much, requiring corrections and refunds.
Why It Matters
Getting the definition of compensation right isn’t just about avoiding errors—it impacts key parts of your 401(k) plan, including:
- Accurate Contributions: Contributions are typically based on a percentage of compensation. Errors mean over- or under-contributions.
- Compliance: The IRS enforces limits on compensation and contributions. Missteps could result in penalties.
- Fairness: Applying the rules consistently ensures equal treatment and avoids discrimination issues.
- Testing Success: Non-discrimination and contribution limit tests depend on accurate compensation figures.
- Employee Trust: Clear rules help employees understand how their retirement savings are calculated.
Ready to ensure your 401(k) Plan is on Track?
Understanding how compensation is defined in your plan is necessary to keep your plan running smoothly, avoid costly errors, and ensure compliance with IRS rules. Take the time to review your plan, train your team, and coordinate with payroll and TPAs to get it right the first time.
