Compensation is Simply Compensation, Right?

Compensation is Simply Compensation, Right?

by Michael Bourne

This is the “Information Age,” so how hard can it be to determine how much we paid our employees last year?  It may not be that hard given a certain set of parameters, but compensation miscalculations are the among the most frequent and costly mistakes made by 401k and 403b plan sponsors. For retirement plans, “compensation” generally includes all payments made by an employer to an employee for services rendered in the scope of the employer’s business. Simple enough, right?

{This article does not discuss how to determine compensation for the self-employed, which includes business owners of partnerships, LLCs and S Corporations.}

Did you know there could be more than one definition of compensation in your plan?

The problem first arises from the fact that compensation is used for different purposes in administering a qualified retirement plan, and compensation could be defined differently for each of these purposes.  For example, a plan sponsor may choose to exclude bonuses, overtime, or other types of payments from compensation for certain plan purposes, but not for others.

A commonly used and permissible compensation definition is “W-2 Compensation.”  This is usually defined similarly to this excerpt from a typical plan document:

Compensation

  1. Definition of Compensation for purposes of allocations:
  2. [ X ] W-2.  Wages within the meaning of Code section 3401(a) and all other payments of compensation paid to an Employee by the Employer (in the course of the Employer’s trade or business) for which the Employer is required to furnish the Employee a written statement under Code sections 6041(d), 6051(a)(3), and 6052.

This definition makes it sound like there should be a Box on the W-2 where you can simply and consistently pull the correct compensation amounts for every participant, but not so fast.

  • Box 1 (Wages, tips, other compensation) is where total taxable wages are reported, but you must add back all pretax deductions, such as 401(k) deferrals, for many plan purposes. Also, plan compensation may not include severance pay, so it would need to be removed.  So, taking the number in Box 1 doesn’t do the trick.
  • Box 3 (Social security wages) can be eliminated as a consistent source of compensation, because its amount is limited to the maximum FICA wage base ($127,200 for 2017 and $128,400 in 2018), and plan compensation is not.
  • Box 5 (Medicare wages and tips) is likewise not a consistent source for all plans, because it does not include participant pretax contributions to Section 125 cafeteria plans and Section 129 dependent care plans, which are included in compensation for some retirement plans.

Another common reason Forms W-2 aren’t sufficient for compensation purposes is that many plans have a July 1st (and January 1st) entry date and exclude compensation prior to a participant’s entry into the plan.  This means any compensation earned prior to the July 1st entry would need to be subtracted from compensation for mid-year entrants.

Please put this lesson into a box for me…

Since it must provide complete and accurate information in the census data provided to the third party administrator (“TPA”), the plan sponsor needs to fully understand its plan’s definition(s) of compensation and how to consistently gather that information.  First, ask your TPA for help.  Second, you may find it easiest to start with Box 1 wages (or Box 5, depending on the items being included in compensation) and adjust for the items (in separate columns on a worksheet) needed to get to the plan’s definition of compensation.  This should allow for easier reconciliations (both per participant and in total) and clearer communications.

If you are reporting only one compensation amount for each employee to your TPA, make certain the definition for compensation is the same throughout the plan document.  Your TPA should be able to help you verify this, as well as provide you with a template for reporting the census data.

Mike Bourne is the managing partner for Atéssa Benefits, a TPA firm specializing in defined benefit (DB) plan administration and ERISA Compliance.  He is also a partner in MB Actuarial Services, which provides outsourced services to over 700 DB plans for other TPA firms.  Both firms are located in San Diego, CA.  He is also a CPA and an MBA from the University of Chicago.

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