Understanding and Administration of Plan Defined Compensation and Eligibility

Payroll administration plays a critical role when an employer offers a retirement plan, and understanding the plan document provisions is important to avoid operational failures. According to the Internal Revenue Service (IRS), failure to follow the plan’s definition of compensation for determining contributions and failure to include eligible employees or to exclude ineligible employees are two of the top ten mistakes.

Plan Compensation Definition

First, the payroll department should be aware of the retirement plan’s base definition of compensation. Base compensation can be defined as wages, tips and other compensation on Form W-2, code 3401(a) wages for withholding purposes, or 415 safe harbor compensation. Next, there should be an understanding of any adjustments to the elected base compensation. A few examples of possible compensation exclusions are overtime, bonus, and compensation prior to an employee being a participant in the plan. At times, the plan may be designed to allow a type of compensation to be included in the employee deferral calculation, yet not in the profit-sharing calculation. It is very important the payroll system is set up properly for employee deferral and employer contribution calculations to be made accurately.

The payroll department should have knowledge that upon the establishment of a new payroll earnings code, a potential amendment to the retirement plan may be desired. For example, if an employer added a shift differential earnings code and did not wish to increase match and/or profit sharing expense, the plan should be amended to reflect the desired adjustment to compensation.

Although there is flexibility for employers to design the plan with various compensation adjustments, often the employer elects to only exclude the forms of compensation that can be excluded to meet 414(s) test requirements. Allowable forms of exclusion are compensation earned prior to the employee becoming eligible to participate in the plan, reimbursements or other expense allowances, moving expenses, fringe benefits (cash or non-cash), certain deferred compensation and welfare benefits.

The plan definition of compensation typically includes bonus compensation, yet employees may desire to defer a different amount into the retirement plan for bonus pay. If an employer is willing to take on the additional administrative burden, they may provide employees with the option to complete and sign a bonus election form to provide direction for a different deferral amount on bonus compensation. Some plans may not wish to assume this additional burden. In this case, the employer may suggest the employees elect a different deferral rate on the website between specific days, and then after the bonus pay date, log back onto the website to elect their normal deferral rate. If the retirement plan is subject to Actual Deferral Percentage and Actual Contribution Percentage testing and passing this test is within a close range, the risk to the employer is too many employees may elect to not defer on bonus or a lower rate, thus potentially causing the test to fail and highly compensated employees incurring returns.

When employees terminate employment, the plan document is typically designed to include compensation paid within 2 ½ months after the termination date or by the end of the plan year for the final payroll, cash out of unused vacation or commissions. However, it is important to be aware compensation may never be included nor deferrals taken on severance package payments.

Eligible Employees

Payroll administration instructions and monitoring should include the understanding of when an employee has met plan eligibility and entry requirements and should not submit deferrals to the 401(k) plan sooner than when the employee meets these requirements. Additionally, there should be awareness of rehired employees, who had met the eligibility and entry during prior employment, being allowed to participate in the plan immediately upon rehire. Generally, rehired employees do not have to meet the eligibility and entry requirements again.

There may also be excluded employee classifications defined in the plan document. For example, the plan sponsor may have established the plan document to exclude interns from participating in the retirement plan. If the intern is hired as a full-time employee, the employee’s service time as an intern counts towards eligibility. For example, if the intern worked for the employer for six months and the eligibility period was 90 days, the employee is eligible to participant in the plan immediately upon placement into the full-time position and should be provided enrollment materials to participate per the first pay date as a full-time employee, or automatically enrolled, if applicable.

A plan may dictate that an employee must have a year of service (1,000 hours or 12 months of elapsed time) and attainment of age 21. This is the maximum service and age requirement allowable. Once an employee meets these eligibility requirements, the employee enters the plan based upon the plan definition of entry, which may be immediate, monthly, quarterly or semi-annually. To add to the complexity of payroll administration, different definitions of employee eligibility and entry may be applied to different aspects of the plan. For example, a plan may be designed as 90 days of service and monthly entry for employee deferrals yet require one year of service and semi-annual entry for the employer profit-sharing contribution.

As a plan fiduciary, a due diligence process should be established to periodically review payroll administration of the plan definition of compensation and eligibility to monitor the operation accuracy of elective deferrals submission and calculation of employer contributions. Payroll errors can be costly to fix if the error is not identified within a short period of time. When mistakes are identified, they should be addressed promptly, and Greenleaf Trust is here to help work through the required correction. Please reach out to your plan’s relationship manager if you have any questions about this topic or any other aspect of your plan design.