Utilizing Correct “Compensation”
Participant 401k elective deferral elections represent just what they’re titled, i.e. an election to defer all or a portion of the participant’s current “compensation”, or what would have been paid to the participant in cash, but for the election.
While the term “compensation” is often used to mean “pay” or “salary”, each of these terms may vary slightly. However, as with many provisions contained in a plan, the term must be clearly defined in the governing plan document. That definition serves to set forth an unambiguous set of rules to follow for every plan participant, thereby providing consistency and anticipated outcomes.
How 401k Deferrals are “Elected”
Most plan documents permit elections of a specific dollar amount, or percentage of compensation, with the former being less of an issue with regard to the definition of compensation. Where the election is in the form of a percentage, the application of that percentage to the definition of compensation must be applied. If the plan’s definition of compensation is something like “gross wages”, or “wages subject to withholding”, bonuses, overtime, sick pay, etc. would not be excluded. Therefore, a participant election to defer, for example 4% of compensation, would be applied to all compensation (including bonuses, overtime, etc.). Failure to do so results in a failure to follow the terms of the plan document, which is a disqualifying event.
The plan document may also directly set forth the timeframe during which a participant may make modification to their election, or indirectly through other established policies or procedures. Adherence to the stated timeframes is also required. In order to provide flexibility to participants in making elections specific to bonuses (where bonuses are included in the definition of compensation), a timeframe that provides that the participant can modify their election “at any time” is warranted. Of note too, is the importance that all elections be made in writing, via a form or electronic system specifically used for this purpose.
Audits may Focus on 401k Elective Deferrals
The governing entities have done some outreach to the employer community, and have identified errors in this area to be common. As a result, they have focused their audit initiatives here, and have increased communication surrounding the corrective measures for this type of error. Specifically, the IRS has developed and continues to refine the Employee Plans Compliance Resolution System (EPCRS), with the most current version of the program released under Revenue Procedure 2013-12. Pinnacle Plan Design, LLC provides consulting services associated with navigating through the corrective measures for such an error.