Costly compensation errors

One of the most significant errors in retirement plans is the calculation of compensation for plan contributions. The IRS views such errors as very serious, with consequences that can lead to operational failures and ultimately, disqualified status. Here are examples of compensation errors:

–          Contributions to the plan by the employer on base compensation only. If a plan document states that profit-sharing contributions are to be calculated for base compensation plus commission, be sure that contributions are also made for commissions paid to the employee.

–          Exclusion of overtime or other ‘extra’ pay from definition of compensation. If overtime or other pay is excluded, then the contribution rate becomes unequal for highly-compensated vs. non-highly-compensated employees.

–          Using a higher amount of compensation than allowed by the IRS Code §404. Going above the approved IRS amount may result in a nondeductible contribution and the employer owing additional tax, including excise tax.

–          Failure to use the IRS’ statutory definition of compensation. The IRS specifies limits and minimums.

Here are tips from the IRS to avoid compensation-related failures:

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