Summertime is for fun, relaxation and a break from work, but it is also a crucial period for calendar year 401(k) plans. Form 5500 Annual Return/Reports are due July 31 for these plans, and even if an extension to October 15 is obtained, the summer months are when plan operations and finances are under scrutiny. This is particularly true for “large” plans – those with 100 or more participants on the first day of your last plan year. (Note that special transition rules apply when switching from small plan to large plan Form 5500 filing status and back again, under the “80/120 rule.” A good explanation of the rule is found here.) Sponsors of large plans must engage an independent qualified public accountant (IQPA) and attach the auditor’s report to their Form 5500.
As a benefits attorney, I associate summer with calls from plan sponsors whose auditing CPAs have identified operational failures and other plan errors that require correction under Internal Revenue Service and Department of Labor voluntary compliance programs, including self-correction, when available. This is the first in a series of posts covering the 401(k) mishaps that are as reliable a feature of my summers as are the 4th of July, outdoor barbecues and sunscreen.
Error No. 1: Mismatching Definitions of Compensation
Disconnects between payroll procedures, and the way that your 401(k) plan defines “compensation” for purposes of salary deferrals and employer contributions, generate a significant number of plan operational failures that I see.
Examples include adding payroll codes to your system without applying participants’ deferral elections and employer contribution to those new payroll amounts, or carving out categories such as bonuses, commissions, and overtime from your plan’s definition of compensation, without stopping deferrals and employer contributions from those amounts. Whole categories of pay – for instance, tips recorded on credit cards – can sometimes be overlooked in plan operations, as well. These errors can be corrected fairly simply but the corrections can be expensive and/or time consuming if the errors cover multiple years.
The best recommendation I can make to avoid compensation-based errors in operating your 401(k) plan is to use Form W-2, Box 1 as your plan’s definition of compensation, with no exclusions (other than gift cards or cash rewards, if your company uses them) and to regularly revisit your payroll codes and procedures to make sure that all pay items that appear in Box 1 are counted for purposes of participants’ salary deferrals and loan repayments.
Specifically, you should consider holding a meeting each year, or more frequently, among human resources and payroll personnel (in-house or out-sourced) to review the definition of compensation in the Adoption Agreement, on the one hand, and a list of all payroll codes, on the other. Revisit this exercise every time you modify payroll practices, your payroll vendor or software, or of course any time you change the plan’s definition of compensation.
If your plan defines compensation in a way that involves carve-outs, be especially careful to ensure that the salary deferrals and employer contributions are not applied to the payroll code amounts that correspond to the exclusions, whether bonuses, commissions, overtime, or other items.
Be mindful, as well, that certain pay items may be excluded from “safe harbor” definitions of compensation, such as cash and/or non-cash fringe benefits, reimbursements or other expense allowances, and moving expenses, but that other exclusions, such as overtime, will trigger the need for annual testing of the definition of compensation under nondiscrimination rules.
Lastly, there is a good bit of confusion over the scope of certain categories referenced in the safe harbor definitions of compensation, such as nontaxable fringe benefits, and differential wage payments. As used in an adoption agreement, differential wage payments generally will relate to military service and are not the same as shift differentials. When in doubt about any definition of compensation issue, check with your third party administrator, ERISA attorney or other benefits professional. You want your only headache next summer to be from an ice cream cone, not your 401(k) plan.
The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2021 Christine P. Roberts, all rights reserved.
Photo credit: Krissara Lertnimanorladee, Unsplash