A recurring problem encountered with many 401k audits is the treatment of severance pay and subsequent compensation. To properly determine whether compensation paid to an employee during or after his dismissal is considered as compensation eligible for 401k purposes, it is important to distinguish whether it is severance pay or after compensation. These terms are often used interchangeably, but the nature and timing of the payment determine whether the payment should be included or excluded in the compensation for the calculation of elective deferrals for a 401 (k) plan. Also, see this post from last year @TN0krJG
IRS SEPARATION AND COMPENSATION AFTER DEFINED SEVERANCE
To begin, a basic understanding of certain IRS regulations regarding compensation is required. Substantially, all 401 (k) plans base their compensation definition on one of three safe harbor definitions included in the IRS regulations. These three definitions of safe harbor comply with §415 of the Internal Revenue Code, which is one of the two sections of the code where compensation is defined. According to the three definitions of safe harbor, severance pay paid after termination of an employee's employment is excluded from compensation eligible for 401 (k) postponement purposes, but post-compensation compensation may or may not be included, Depending on certain rules.
The severance pay is the payment received by an employee as part of an agreement between the leaving employee and the employer. It is often based on a combination of the employee's current salary and years of service. The IRS regulations do not specify whether compensation for dismissal distributed before termination of employment can be included. If you pay severance pay before termination of employment, you should consult with your administrator, auditor or outside attorney to determine if 401k should be withheld.
The IRS defines post-compensation compensation as the compensation that would have been paid if the compensation had not occurred. It is important to note that there are certain types of post-compensation compensation that qualify as compensation under §415. If compensation after compensation had been paid if the employee had not been dismissed from employment, such as compensation for hours worked until the employee's compensation date, but was not paid until after the date of compensation, and compensation It is paid before (1) 2 and a half months after the compensation or (2) the end of the plan year in which the compensation occurs.
PAYMENT AFTER THE SEVERANCE INCLUDED IN THE DEFINITION OF COMPENSATION
For example, an employee is fired on a Thursday. The employee has hours worked from Monday to Thursday of that week. Those hours are included in the employer's payroll on the second Friday after the employee's termination date. That compensation would be eligible for postponement 401 (k).
PAYMENT AFTER SEPARATION EXCLUDED FROM THE DEFINITION OF COMPENSATION
The amount of time between when an employee earns compensation and when paid can be greater in the case of commission payments, bonuses, etc. As another example, consider the following three facts: (1) a seller receives a commission that pays the second payment in January of year 2 for sales in the fourth quarter of year 1, (2) this employee terminated employment on January 15 October of year 1, but had sales that earned commissions during the period from October 1 to October 15, and (3) the plan year end is December 31.
Since the second January payment will be 2 and a half months after the employee's compensation and after the end of the year of limitation, compensation in this example would be excluded even if the commission payment is normally included in the definition of compensation for employees not separated.
ACCUMULATED CASH PROBLEMS
One type of post-severance pay that may cause problems for employers is the withdrawal of cash from the accumulated licenses, but not used for illness, vacations or other licenses that could have been used if the compensation had not occurred. If employers pay this type of compensation, they must specify in their plan documents or adoption agreements whether this compensation is included or excluded and then ensure that the provisions of the plan document are complied with in practice.
CHECK WITH AN ADVISOR
If you need help navigating through these complex IRS regulations or suspect that you may be calculating compensation for plan purposes incorrectly, you do not have to wait for the IRS or DOL to discover it. Review the definition of compensation in your plan document and the provisions for compensation