401(k) Find and Fix: Compensation Mistakes

Geek Out!


MISTAKE: You didn’t use the plan definition of compensation correctly for all deferrals and employer non-elective contributions, such as profit-sharing contributions.
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 purposes of elective deferrals, employer matching and/or non-elective contributions and nondiscrimination testing. A plan’s compensation definition must satisfy Internal Revenue Code 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 calendar 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’s compensation definitions. A typical 401(k) plan definition of compensation 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. Common mistakes include 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 elective deferrals, employer contributions and testing. Many plan sponsors operate their plan based on a plan summary of the definitions and operational requirements. If the actual plan document is amended to make a change to the definition of compensation, and supporting documentation is not changed to reflect the plan amendment, the plan may continue to inadvertently operate as it had previously.

Review the plan sections dealing with elective deferrals, employer contributions and nondiscrimination testing. These sections may say, for example, “Employees may defer up to 15% of their Compensation…” You then have to refer to the plan section containing definitions and find the “Compensation” definition. Read through the definition to see if you’re using the correct definition of compensation for the purpose – elective deferrals, employer contributions, or nondiscrimination testing. 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 help you determine the correct amounts.

How to fix the mistake

Corrective action

There is more than one way to make corrections when you have improperly allocated amounts because you didn’t correctly follow the plan definition of compensation. Perhaps the most commonly used method is referenced in the IRS “401(k) Plan Fix-It Guide” which appears on the IRS website, and which would be employed as a correction method in conjunction with the EPCRS Self-Correction Program (SCP) or Voluntary Correction Program (VCP) (see discussion below). If you’ve improperly determined elective deferrals, you can generally give the participant a distribution of the excess amount plus earnings. If the plan made employer contributions, such as profit-sharing allocations, in an greater amount that would have been made had the proper definition of compensation been followed, you can usually forfeit and reallocate the excess contributions plus earnings to all plan participants, or, alternatively, if the plan so provides, deposit the amounts in a separate, unallocated plan account designated solely for purposes of holding these monies for later use as employer contributions. Of course, an erroneous application of the plan definition of compensation allocation may also result in participants receiving too little. If this happens, the plan may make a corrective contribution to all affected participants in an amount necessary to bring their accounts up to where they would have been, including earnings, had the proper definition of compensation been followed.

Employer Z sponsors a 401(k) plan with six participants. The plan definition of compensation for elective deferrals and profit-sharing contributions (which are non-elective contributions) was amended, effective 2020, to exclude bonuses. For the 2021 plan year, due to an internal communication failure, Employer Z improperly included bonuses in compensation when determining elective deferrals profit-sharing contributions. 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, under either SCP or VCP, forfeits the profit-sharing allocations of $1,500 plus earnings and puts the funds in an unallocated account to use for profit-sharing allocations in future years, and distributes the improperly allocated elective deferrals of $1,800 plus earnings to each of the three affected employees.

Correction programs available

The IRS Employee Plans Compliance Resolution System (EPCRS) includes three separate programs, briefly described below, which may apply in this situation:

Self-Correction Program (SCP)
The example illustrates an operational problem because Employer Z didn’t follow the plan terms because it improperly included bonuses in compensation when determining elective deferrals and employer non-elective contributions. If the other eligibility requirements for SCP are satisfied (for example, the plan has established compliance practices and procedures in place), Employer Z may use the Self-Correction Program (“SCP”) to correct the mistake.

The correction method could be identical to the method outlined above (as referenced in the “401(k) Plan Fix-It Guide”) or it could be another correction method authorized for use under the same circumstances in the EPCRS guidance (Revenue Procedure 2021-30).

Because certain questions remain unanswered, pending issuance of the updated Revenue Procedure that fully incorporates the new SECURE 2.0 provisions, plan sponsors are strongly advised to consult with their legal counsel or other professional ERISA advisor prior to using SCP to correct mistakes.

Employer Z should fully and carefully document the steps taken to make the correction under SCP.

Voluntary Correction Program (VCP)
The correction method may be the same as described previously or another correction method permitted under the EPCRS guidance. Employer Z makes a VCP submission. Under current IRS guidance, if Employer Z’s plan has less than $500,000 in assets, the fee for the VCP submission is $1,500. When making the submission, Employer Z must file electronically using the www.pay.gov website, must include Forms 8950 and 8951 and consider using the Model VCP Compliance Statement as provided in Revenue Procedure 2021-30, along with any related supporting documents.

Audit Closing Agreement Program (“CAP”)
Under Audit CAP, the correction method may be the same as under SCP, but this will be subject to negotiations with the IRS. Employer Z and the IRS enter into a closing agreement outlining the corrective action and negotiate a sanction based on the maximum payment amount – which will be greater than the VCP user fee would have been. Since the plan sponsor is responsible for the correct administration of the plan, expenses such as fees and sanctions under Audit CAP are generally not payable out of plan assets. (See “Plan Assets” for details.) Further after the IRS finds the mistake on plan audit or otherwise, Audit CAP is 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