As we work through another testing season, we are reminded of the influence compensation has throughout retirement plan administration. Whether identifying or measuring it, employee compensation affects just about every aspect of our industry. The potential nuances and complexities can be maddening to even the most seasoned professional.

But there are ways to avoid some of the nuance and complexity. The first step is recognizing the three core compensation definitions.

• Statutory (415) Compensation
• Allocation or Accrual (Plan) Compensation
• Testing Compensation

Understanding the objective and purpose of these three definitions allows you to avoid pitfalls while assisting clients in making practical decisions. Granted, a 1,000 word blog cannot solve all compensation issues. The goal here is to discuss broad concepts within these three definitions to set the stage for more in-depth review or discussion.

Statutory (415) Compensation

The cornerstone of any compensation definition for retirement plans is statutory (aka 415) compensation. There are three methods to identify 415 compensation:

• Current Includible Compensation
• Section 3401(a) Wages (aka Wages for Income Tax Withholding)
• Wages Reported Under Sections 6041, 6051 and 6052 (aka W-2 Wages)

Which method should an employer choose? The decision doesn’t matter for almost all employers, because each method includes just about every type of pay to an employee. The rare examples of excluded pay include worker’s compensation or nontaxable fringe benefits. Even though there are also slight differences between each method, the differences are unique payments unlikely to be used by most employers. For example, some payments from an accident/health plan are included in current includible compensation but excluded in W-2 wages.

Selecting which method to use is less important than properly including all necessary amounts. It would be nice if it was as easy as looking at Box 1 on the W-2. Unfortunately, all methods for identifying 415 compensation include elective deferrals and other salary reduction amounts made under cafeteria plans. So if the W-2 wages option is selected, remember that additional amounts, like 401(k) plan pre-tax deferrals, need to be added to Box 1 to arrive at 415 compensation.

There are only three administrative functions which require the use of the 415 compensation definition:

• Establishing the benefit limit under section 415 ($72,000 in 2026)
• Calculating top heavy minimum benefits
• Determining highly compensated employees or key employees

However, you may want to consider using 415 compensation for defining plan or testing compensation below. Doing so avoids the burden and risk of errors in using different compensation definitions for different functions. This may make life easier for both you and your clients.

Allocation or Accrual (Plan) Compensation

When reviewing a plan document, all of the selections and parameters under the compensation section make up what is known as plan compensation. Plan compensation is used to calculate contribution or accrual amounts, such as elective deferrals, match or nonelective contributions. You can generally define plan compensation in any number of ways. The plan document likely even includes an “other” line in the compensation section for full flexibility.

But just because you can, doesn’t mean you should. The easiest approach may be to use 415 compensation (i.e., no pay exclusions) as plan compensation. That way you only need to worry about one compensation definition for plan operations. Using different definitions, such as excluding bonuses from plan compensation, increases the risk of errors. You now must ensure that the pay information provided by the employer or payroll provider distinguishes the excluded pay. Either you or the employer will also have to monitor contributions to ensure any exclusion, such as bonuses, is not used in calculating contribution amounts, but included when defining 415 compensation.

Without adequate procedures and monitoring, there is a good chance errors will occur that take time and effort to fix when discovered. Using 415 compensation can reduce that risk and streamline administration. Moreover, if the employer is concerned about handling certain pay, like bonuses, those may be resolved by other plan features. For example, a plan may have separate deferral elections for regular payroll and bonuses to resolve any potential issue of deferring from bonus pay.

In addition to complexity, a desired plan design may prevent the employer from excluding certain pay. Many popular plan designs require compliance with testing compensation requirements – see below – such as safe harbor 401(k) plans or design-based nonelective allocations (i.e., pro rata or permitted disparity). Those testing compensation requirements may prevent an employer from excluding certain pay. Making matters worse, if excluded pay eventually becomes an issue for the desired plan design, the plan document needs to be timely amended to change the plan compensation definition.

Testing Compensation

Testing compensation is where you can set yourself apart as a service provider. It is used in annual nondiscrimination testing, such as ADP, ACP and rate group tests. It is also required for popular plan design such as contributions to safe harbor 401(k) plans. By knowing what you can, and cannot do, with testing compensation, you can guide clients in consistently passing nondiscrimination tests or easing administration.

Unlike plan compensation, testing compensation does not need to be defined in the plan document. The employer and you can decide what pay should be included or excluded each year. Your only restraint is a nondiscrimination test for compensation under Internal Revenue Code 414(s). In general, there can be no more than a minimal difference in compensation averages between highly compensated and non-highly compensated employees to pass the 414(s) compensation test.

You can use this flexibility to assist employers in hitting desired contribution levels or saving them from test failures. The key is understanding that you can allocate contributions under one compensation definition but complete testing under another definition. Another critical piece is that you receive detailed pay records from the employer or payroll provider. You will need this breakdown to evaluate which compensation amounts meet the plan’s desired goals while also passing the 414(s) compensation test. Most or all of this can be completed without burden to the employer.

On the other hand, understanding the requirements for testing compensation can help you steer clients away from making poor decisions and ease your administrative tasks. For example, you can prevent an employer from excluding overtime pay from plan compensation by looking at payroll records. You may notice that overtime is only paid to nonhighly compensated employees, which means plan compensation is unlikely to meet testing compensation requirements. On the other hand, testing compensation that includes overtime may not pass the applicable nondiscrimination tests. Guiding the employer through this analysis before any formal decision is made demonstrates your value over other service providers.

Helping Both You And Your Clients!

You are serving your clients best when you know which compensation definition is needed for each aspect of retirement plan administration. You can reduce both the employer’s and your workload by selecting the best option for 415 compensation and defining plan compensation in an appropriate manner. You can also maximize the employer’s satisfaction with their plan by utilizing testing compensation to balance plan compensation. Or you can make it easy for everyone by ensuring all administrative aspects use one compensation definition.

Yes, there is a lot more that goes into compensation than just recognizing these three definitions. But starting with this foundation allows you to dig deeper into understanding other details or distinctions. Consider how the compensation definition you use for one administrative aspect may help or hinder another one. Happy testing season!

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About the Author

Brian Furgala, Esq., CPC, QPA is Senior Director, Retirement Services Strategy for PenChecks, a leader in outsourced retirement plan distribution processing and Automatic Rollover/Missing Participant IRAs and related services. His broad experience as an ERISA attorney and senior executive for several leading retirement plan service providers gives him a unique perspective on the industry.

The views expressed in this article are those of the author and do not necessarily represent the views of PenChecks Trust®, its subsidiaries or affiliates.