One of the most common errors found in qualified retirement plans is the failure to use the correct definition of compensation.  Compensation is a key data point in retirement plan operations for employer contribution allocations, nondiscrimination testing, and annual additions limitations, just to name a few.

Definitions of Compensation

There are three basic definitions of compensation: (1) §3401(a), (2) W-2 , or §6041 and §6051, and (3) Simplified §415.

3401(a) is wages used in determining income tax withholding adjusted for the following:

• Includes elective deferrals
• Includes nonqualified plan distributions
• Includes qualified transportation fringe benefits
• Includes taxable fringe benefits, with the exception of P.S. 58 cost
• Includes taxable moving expenses

6041 and §6051 compensation is the same as §3401(a) wages except it includes P.S. 58 cost.

Simplified §415 compensation is all wages and payment for services adjusted for the following:

• Includes elective deferrals
• Includes qualified transportation fringe benefits
• Includes taxable fringe benefits, including P.S. 58 cost
• Excludes medical and disability benefits, taxable moving expense, stock options granted, and non-qualified deferred compensation (unless the plan elects to include)

Severance Pay

It is important to point out that severance paid after separation from service is excluded per the Section 415 regulations.  Severance pay is not pay for services rendered.  Therefore, it cannot be considered as part of the definition of compensation.

Additional adjustments

A plan can elect to use any one of the above definitions of compensation and can make additional adjustments.  For example, a plan can elect to exclude all fringe benefits, exclude overtime, bonuses and commissions and only consider pay while an employee was eligible to participate in the plan.  Excluding overtime, bonuses and commission will require additional testing for nondiscrimination.

2024 Limit

Each year the IRS sets a limit on how much compensation can be recognized for plan purposes.  For 2024 that limit is $345,000.  Anything earned above that amount is disregarded for plan purposes.

When incorrect compensation is used, it can cause errors in contribution calculations and testing.  It is important to review how your plan defines what is included in compensation and that it is correctly set up in your payroll system.

The above provides basic information on the definition of compensation. Please contact us to schedule a consultation if you need additional guidance in determining your plan’s definition of compensation.