Back in the day, compensation was simpler. Hourly wage or annual salary was the main difference. But money has grown more complex, and that has affected perhaps the most unassuming yet complex factor of a retirement plan: its definition of compensation.
Do you give your employees bonuses? Well, they could be included (or excluded) in compensation for your 401(k) or other qualified retirement plan. Commissions? They could (or could not) be included in compensation. Overtime? Same story.
And what about the weird things? Items like moving expenses, stock options, foreign earned income, and group term life insurance. You can see the endless headaches this could cause and mistakes that could be made. What is the solution? Cue entrance for the question of the hour: what does YOUR plan say about compensation?
Who cares, anyway? The IRS, for one.
The IRS serves as the watchdog for the Department of Labor to ensure that plan participants are getting what is owed to them. And when plan sponsors (AKA employers) do not adhere to the retirement Plan Document, those business owners should prepare to start writing extra checks to the retirement plan, the IRS, or both.
Vital to this topic is the Plan Document. The Plan Document serves as the Bible of the retirement plan. Although the Plan Document can be flexible during the design or amendment process, once it is finished it sets in stone the actions the plan sponsor must take.
A $600 mistake, but a $60,000 bill.
Consider the following example. An employee, Jon, earns $90,000 in base salary and receives a $20,000 bonus, bringing his total compensation to $110,000. His employer offers a 3% nonelective Safe Harbor contribution, meaning the company contributes 3% of each eligible employee's compensation to their retirement account on their behalf.
Jon's plan document does not exclude bonuses from eligible compensation. However, his employer incorrectly assumes that only base salary qualifies. As a result, the employer contributes $2,700 (3% of $90,000) rather than the $3,300 (3% of $110,000) that Jon is owed. It’s a $600 mistake. No biggie, right?
Three years later, the plan has grown to a size that requires a mandatory audit. The auditors identify the same error for Jon and 50 other participants. That $600 discrepancy is now multiplied across dozens of employees and several plan years. The total cost to fix? $60,000.
How do we fix it?
These missing contributions are an operational error, and so can be corrected via the IRS Employee Plans Compliance Resolution System (EPCRS), and specifically through their Self Correction Program. As the name suggests, the employer must correct the error themselves. The plan sponsor must not only make up the missing contribution ($600 for Jon) but all the lost earnings that the missed contribution would have earned in the period of failure. For one participant, this may not be a huge sum. Multiply it by the other 50 participants, and suddenly you may find yourself looking at a $60,000 bill.
How do we avoid the problem altogether?
I’ll admit, corrections like this example are never fun. Not only do you end up writing extra checks to the retirement plan to make up missing contributions and lost earnings, but you’ll probably pay a fee to a consultant to calculate the lost earnings amount for each participant. Yuck! So how can a business owner avoid this issue entirely? By reading YOUR plan. The Plan Document specifies the exact definition of compensation that should be used. Ask yourself now, what does your plan say about compensation? And keep a look out for future Brown Edwards articles that dive deeper into the complexities of plan compensation!
Not sure how your plan defines compensation? Concerned that your plan may not be designed to maximize your own retirement? At Brown Edwards, we specialize in answering your retirement plan questions, administering retirement plans of all types, and helping business owners design plans that fit their financial goals. Whether you’re looking to stay compliant with SECURE 2.0, avoid the pitfalls that compensation can cause, or create a retirement strategy customized to you, we’re here to make it simple and stress-free. Let’s talk about how we can help you build a stronger financial future. Fill out the poll below and we will reach out to you in a timely manner.