401(k) Find and Fix: Compensation Mistakes


Geek Out!

 

MISTAKE: You didn’t use the plan definition of compensation correctly for all deferrals and allocations.
Find the Mistake Fix the Mistake Avoid the Mistake
Review the plan document definition of compensation used for determining elective deferrals, employer nonelective and matching contributions, maximum annual additions and top-heavy minimum contributions. Review the plan election forms to determine if they’re consistent with plan terms. Corrective contribution or distribution. Follow the ComplianceDashboard prompts that encourage you to perform annual reviews of compensation definitions. Ensure that the person in charge of determining compensation is properly trained to understand the plan document.

 

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 the dollar amount set by the IRS to be in effect for the particular year, which is subject to cost-of-living adjustments (see 401(k) Retirement Plan Limits  for the current year limit). 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:

Your plan may contain different compensation definitions for different purposes. In some cases, you or the plan administrator may use an incorrect definition in determining the compensation eligible to be deferred, computing the matching contribution or in calculating the ADP or ACP test. Also, you may fail to limit compensation as required by IRC Section 401(a)(17).

How to find the mistake

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 mistake

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 improperly determined elective deferrals, give the participant a distribution of the excess amount plus earnings. If there are improper profit-sharing allocations, forfeit and reallocate the allocations plus earnings to plan participants or put them in an unallocated account for later use. Of course, an improper allocation may also result in an under contribution. If this happens, make a corrective contribution, including earnings, for the affected participants.

Example
Employer Z sponsors a 401(k) plan with six participants. The plan definition of compensation for deferrals and allocations was amended, effective 2005, to exclude bonuses. For the 2019 plan year, Employer Z improperly included bonuses in compensation when determining allocations and deferrals. Three highly compensated employees each had base compensation of $120,000 and a $30,000 bonus. Each of these highly compensated employees had deferral percentages of 6% of compensation and the plan provides for a fixed profit-sharing allocation of 5% of compensation to each participant’s account.

For each employee, Employer Z should forfeit the profit-sharing allocations of $1,500 plus earnings and put the funds in an unallocated account to use for profit-sharing allocations in future years and distribute the improperly allocated elective deferrals of $1,800 plus earnings to each of the three employees.

Correction programs available

Self-Correction Program
The example illustrates an operational problem because Employer Z didn’t follow the plan terms by including bonuses in compensation when determining plan allocations. If the other eligibility requirements are satisfied, Employer Z may use the Self-Correction Program (“SCP”) to correct the mistake.

Voluntary Correction Program
Correction is the same as described under the SCP. Employer Z makes a VCP submission. Employer Z’s plan has less than $500,000 in assets, so the fee for the VCP submission is $1,500. When making the submission, Z must file electronically using the www.pay.gov website, must include Forms 8950 and 8951 and consider using the Model VCP Compliance Statement published in Revenue Procedure 2019-19 and any related supporting documents, as applicable.

Audit Closing Agreement Program (“CAP”)
Under Audit CAP, the correction is the same as under SCP. Employer Z and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount. Once the IRS finds the mistake, Audit CAP may be the only correction method available, so it is important to self-identify and correct errors using SCP or VCP as soon as possible!

How to avoid the mistake