3867 / What is compensation for purposes of nondiscrimination in a qualified plan?

Compensation applies in at least three different ways under the IRC when addressing nondiscrimination requirements for qualified plans.

First, when plans are tested for prohibited discrimination in favor of highly compensated employees, one element of the test is the participant’s compensation. IRC Section 401(a)(4) sets the definition of what constitutes compensation for this purpose.

Second, plans must specify the types of compensation that are used to determine benefits or contributions under the plan.

Third, compensation is used to determine if certain employees are to be treated as highly compensated employees in the nondiscrimination testing.

The nondiscrimination rules of the IRC generally refer to nondiscriminatory compensation as compensation meeting the requirement of IRC Section 414(s). That definition then is tied to the definition of compensation under IRC Section 415(c)(3) and allows for certain modifications.

That listing is not all inclusive, and other definitions of compensation may be used in various testing. For, example, plans must limit the maximum amount of compensation used to determine benefits or to test for prohibited nondiscrimination. No compensation in excess of $350,000 for 2025 (projected) ($345,000 for 2024, $330,000 for 2023, $305,000 in 2022, $290,000 in 2021 and $285,000 in 2020) may be taken into account for these purposes ( Q 3927).¹ The limit is indexed for inflation in increments of $5,000.²

IRC Section 415(c)(3) compensation is the compensation of the participant from the employer for the year.

IRC Section 415(c)(3) compensation is determined under one of the following definitions: currently includible compensation,³ W-2 compensation⁴ or wages for income tax withholding.⁵ The regulations provide a degree of latitude in modifying each of these definitions of compensation.

Compensation generally includes elective deferrals as well as any amounts contributed or deferred by the employer at the election of the employee that are excluded from income under a cafeteria plan, a qualified transportation fringe benefit plan, or an IRC Section 457 plan.⁶ IRC Section 414(s) permits an employer to either exclude or include such deferrals, as described below.

Employers may demonstrate that a definition of compensation is nondiscriminatory using snapshot testing on a single day during the plan year, provided that that day is representative of the employer’s work force and the plan’s coverage throughout the plan year.⁷ This is seldom used in a small plan.

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Planning Point: The definition of “compensation” is important for many reasons in the retirement planning arena, but has gained new importance in light of suspended deductions and exclusions post-tax reform. Retirement plans generally must use the IRC definition of compensation for nondiscrimination testing purposes, which includes, for example, nondeductible moving expenses (but excludes deductible moving expenses). Post-reform, however, all moving expenses are nondeductible. Despite this, the moving expense deduction was only suspended, not eliminated. This is one example of how tax reform has created a level of uncertainty regarding the appropriate definition of compensation while all tax reform provisions remain (at least temporarily) in effect, making it important for plan administrators to evaluate their definition of compensation and consult with qualified tax counsel in determining how to proceed.

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A definition of compensation other than IRC Section 415(c)(3) compensation still can satisfy IRC Section 414(s) if it meets the safe harbor definition or meets one of the alternative definitions plus a nondiscrimination test.⁸ The safe harbor definition is IRC Section 415(c)(3) compensation, reduced by:

(1)  reimbursements or other expense allowances;

(2)  cash and non-cash fringe benefits;

(3)  moving expenses;

(4)  deferred compensation; and

(5)  welfare benefits.⁹

An alternative definition that defines compensation based on the rate of pay of each employee satisfies IRC Section 414(s) if the definition is nondiscriminatory and meets certain other requirements specified in the regulations.¹⁰

An employer generally may elect not to treat as compensation any of the following items: (1) elective contributions to a cafeteria plan, a qualified transportation fringe benefit plan (note that these amounts are no longer deductible for 2018-2025), an IRC Section 401(k) arrangement, a cash or deferred SEP, or a tax sheltered annuity; (2) compensation deferred under a Section 457 plan; and (3) employee contributions to a government employer pick-up
plan.¹¹

Any other reasonable alternative definition of compensation can satisfy IRC Section 414(s) if it does not favor, by design, highly compensated employees and if it meets a nondiscriminatory requirement. An alternative definition of compensation meets the nondiscriminatory requirement if the average percentage of total compensation included under the alternative definition for the employer’s highly compensated employees as a group does not exceed, by more than a de minimis amount, the average percentage of total compensation included under the alternative definition for the employer’s other employees as a group.¹² Self-employed individuals are subject to special rules for purposes of using an alternative definition.¹³

Compensation may have a slightly different definition for other purposes of the IRC.

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Planning Point: Under the FLSA, employers must pay overtime wages to employees who work more than 40 hours per week if their income does not exceed certain thresholds, they are not paid a salary or they perform primarily executive, administrative or professional duties.  The DOL is now increasing the salary levels to give more employees the right to receive overtime pay.  Starting July 1, 2024, the salary threshold is increased to $844 per week and, as of January 1, 2025, employees who earn less than $1,128 per week become eligible for overtime pay.  The rule also increases the annual compensation threshold for employees who are not entitled to overtime pay in most cases to $132,964 on July 1, 2024 and $151,164 on January 1, 2025.  Beginning January 1, 2027, these threshold amounts will be updated every three years for inflation.  Note that job duties will continue to determine overtime exemption status for most salaried employees and state-specific salary requirements may also apply. These rules change the calculus for many retirement plans that base contributions on compensation definitions that include overtime.

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