IRS' 4 Tips for Employers to Avoid Compensation Errors in Retirement Plans

Follow the rules, check for errors, simplify

The IRS on Thursday offered some tips for employers on how to avoid compensation-related mistakes in 401(k) and other types of defined contribution plans.

In the Summer 2011 issue of Retirement News for Employers, the agency noted that the amount an employer contributes to a retirement plan is based on the compensation paid to employees, which is defined in the plan. If an incorrect amount of compensation is used to determine contributions, thes contributions will be incorrect, causing a costly operational failure that could compromise the plan’s qualified status.

The IRS lists four areas that can be affected by use of an incorrect definition of compensation:

  1. A plan operational failure will occur if an employer makes profit-sharing contributions using base compensation rather than base compensation plus commissions as required by the plan document.
  2. A qualification failure may occur if the plan excludes overtime or other pay from its definition of compensation, resulting in highly compensated employees receiving a higher contribution than less well compensated workers—a violation of nondiscrimination requirements.
  3. If an employer uses a higher amount of compensation than the Internal Revenue Code allows, a nondeductible contribution may result. The employer then may owe additional tax, including excise taxes on the excess.
  4. A retirement plan will have a qualification failure unless it uses the statutory definition of compensation. The Internal Revenue Code provides for dollar limitations on benefits and contributions under qualified retirement plans, and the limits are required to be adjusted annually for cost-of-living increases.

To avoid compensation-related failures, the IRS recommends that employers:

  • Review their plan document’s definitions of compensation for each plan purpose.
  • Use the statutory definition of compensation when required.
  • Transmit accurate compensation data for each employee to the payroll processor and plan administrator.
  • Consider amending the plan to use one definition of compensation for all plan purposes.
  • Periodically review the plan for errors and fix them as quickly as possible using IRS correction programs.
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