401(k)ology – Equity Compensation’s Impact on the 401(k) Plan

Among U.S. public companies, equity compensation is already “mainstream,” and it’s commonly offered below the executive level. In the last few years, the bigger shift hasn’t been “equity vs. no equity” as much as how companies use equity compensation. Private companies are increasingly using Restricted Stock Units (RSUs) in later stages and mixing RSUs with options, rather than only options. The shift in equity compensation usage is prompting questions from payroll and benefits professionals because of the impact on the company’s 401(k) plan.

Equity compensation impacts one of the most critical aspects of the company’s retirement plan: plan compensation. This post explains how different types of equity compensation flow into 401(k) plan operations, highlighting how equity compensation may be excluded from plan compensation for contribution allocations but must still be included for statutory purposes, such as determining Highly Compensated Employee and Key Employee status.

Each type of equity compensation is treated differently for tax and reporting purposes. Compound that with the option to use one of three different base definitions of eligible plan compensation in the 401(k) plan, and this can get confusing for HR and payroll teams.

This post provides a high-level review of how the most common employee equity arrangements apply under the three different base definitions used for 401(k) plan compensation. After digesting these complexities (plus a few aspirin), readers should review the 401(k) plan document provisions and discuss any potential changes with the applicable plan service providers.

Equity Compensation

Before diving into the basic definitions used for plan compensation, it is important to identify common forms of equity compensation and their tax structure.

Stock options generally fall into two buckets under U.S. tax law:

• Statutory stock options (also called Incentive Stock Options or ISOs)

• Non-statutory stock options (NSOs or Non-qualified Stock Options, NQSOs)

They differ mainly in tax treatment, eligibility, and administrative requirements.

Statutory vs. Non-Statutory Stock Options

ISOs and NSOs give employees the option to buy stock at a set price intended to be below the current fair market value (FMV).

1. Statutory Stock Options (ISOs)

   • Can only be granted to employees.

   • Often used for executive or key employee compensation.

   • No taxes owed at grant.

   • No taxes owed at exercise (capital gains treatment generally applies to the gains upon sale).

   • No withholding or payroll taxes for the employer.

2. Non-Statutory Stock Options (NSOs or NQSOs)

   • Can be granted to employees, contractors, directors, and consultants.

   • Fewer IRS restrictions on structure.

   • No taxes owed at grant, unless the option has a readily ascertainable fair market value (rare).

   • Taxed at exercise. The spread (FMV – exercise price) is ordinary income.

   • Subject to withholding and payroll taxes.

Restricted Stock Units (RSUs)

RSUs are a third, distinct type of equity award that are not an option at all. RSUs are a promise to deliver actual shares (or the cash value of shares) once vesting conditions are met. RSUs give employees the stock itself (or the cash equivalent), typically taxed as ordinary income upon vesting.

• No purchase/exercise required.

• Vesting is typically time based or performance based.

• When they vest, the employee automatically receives stock or cash.

The tax treatment of RSUs differs sharply from both ISO and NSO stock options.

• No tax at grant.

• At vesting (or, if applicable, upon satisfying a required liquidity event subsequent to vesting), the value of vested shares is treated as ordinary income.

• Subject to withholding and payroll taxes.

Tax Overview of Common Equity Compensation Arrangements:

How Equity Compensation Flows to Form W-2

Equity compensation appears on Form W-2 only when it generates taxable wages for purposes of income tax (Box 1), Social Security (Box 3), or Medicare (Box 5). Note that disqualified ISOs are added to Box 1 of the W-2 but are not subject to Social Security and Medicare withholding.

1. Incentive Stock Options (Statutory Stock Options)

   • Qualifying disposition (meets holding period)

     • Nothing is reported on the W-2.

     • Employee generally pays long-term capital gains rates upon sale.

   • Disqualifying disposition (not meeting required holding periods)

     • Box 1 – (Wages, Tips, Other Compensation)

     • No Social Security or Medicare withholding (not reported in Box 3 or 5)

2. Non-Statutory Stock Options

   • Box 1 (Wages, Tips, Other Compensation)

   • Box 3 & 5 (Subject to Social Security and Medicare)

3. Restricted Stock Units

   • Box 1 (Wages, Tips, Other Compensation)

   • Box 3 & 5 (Subject to Social Security and Medicare)

Basic Plan Compensation: §415(c), Form W2, and §3401(a) wages

Regulatory framework requires §415(c)(3) compensation (including most equity income) to be used for annual limits and testing, even when the plan adopts a narrower compensation definition for allocations. Limits and testing include the compensation used for determining Highly Compensated Employees and Key Employees, which may be different (and usually is) than the compensation used for applying deferral elections and determining employer matching contributions.

§415(c)(3) is the section of the Internal Revenue Code that defines what compensation is for retirement plan limit purposes, while 1.415(c)-2 refers to the Treasury Regulations that provide the specific details and "how-to" for calculating it for plan allocation purposes. Think of it like §415(c)(3) is the law and §1.415(c)-2 is the instruction manual.

Key Distinctions

• Section 415(c)(3): High-level legal definition which states that compensation includes wages, salaries, professional fees, and other amounts received for personal services, while excluding things like deferred compensation or certain tax-advantaged fringe benefits.

• Treasury Regulation 1.415(c)-2: Provides the granular rules. It explains exactly what to include or exclude (like "post-severance" pay) and offers three different "safe harbor" methods for employers to calculate compensation:

  • 415 Simplified: Includes all “includable items” and does not include “excludable items”.

  • W-2 Wages: Simplest method because it uses what’s reported in Box 1.

  • Section 3401(a) Wages: Wages subject to income tax withholding.

Items Includible in 415 Simplified (IRS Reg 1.415(c)-2(b) and Excludable (IRS Reg 1.415(c)-2(c):

The plan document must specify a base compensation definition for contribution allocations using one of the three safe harbors above as the starting point. Following are the distinctions:

• §1.415(c)-(2)(d)(2) “Simplified Definition”
  Includes all taxable compensation (plus certain pretax deferrals) in the “includable list” and does not include the “excludable list” which also excludes equity related wages (RSU vesting income, NSO spreads, ISO disqualifying disposition wages) and pure capital gains (e.g., ISO qualifying gain sales).

• Form W-2 Compensation (Box 1)
  Tracks Box 1 on the Form W-2, so it includes whatever is included there (RSUs, NSOs, ISO disqualifying dispositions), and excludes items that never hit Box 1 (e.g., ISO qualifying dispositions).

• §3401(a) Wages for Income Tax Withholding
  Narrower definition that includes compensation subject to federal income tax withholding. That means RSUs and NSOs are in, while ISO disqualifying disposition wages are out (as not subject to withholding under federal rules). Note that the ISOs disqualifying dispositions are not subject to income tax withholding, which means they are excluded from plan compensation under the 3401(a) wage definition.

How Each Compensation Definition Treats Equity Income

• Simplified Definition
  The Section 415 rules clarify that ISO, NSO, and RSU proceeds are not included in eligible compensation under this definition. (See Treas. Reg. §1.415(c)-2(c)). This definition is not commonly used for defining plan compensation because it tends to be less useful than the other two safe harbor definitions.

Takeaway: Equity compensation is excluded under the §415 simplified definition.

• Form W-2 Compensation (Box 1)
  This definition generally tracks Box 1 of the W-2 (adding certain pre-tax deferrals and Section 125 cafeteria plan contribution) and is frequently used as the base definition in 401(k) plan documents because it is easily attainable.

  • Included:

    • RSU income (included in Box 1)

    • NSO ordinary income (in Box 1)

    • ISO disqualifying disposition income (in Box 1 only)

  • Excluded:

    • ISO qualifying disposition gains (not in Box 1)

    • Any capital gains from stock sales

Takeaway: If it shows up in Box 1 of the Form W-2, it is included in eligible compensation. (Certain compensation not included in Box 1 is also incorporated.)

• §3401(a) Wages for Income Tax Withholding
  This is the narrowest definition. It includes compensation subject to income tax withholding.

  • Included:

    • RSU income (subject to withholding at vest—or, if applicable, a subsequent liquidity event)

    • NSO income (subject to withholding at exercise)

  • Excluded:

    • ISO disqualifying disposition income (NOT subject to withholding → excluded)

    • All qualifying dispositions (no taxable wages from which to withhold)

Takeaway: Only equity events that trigger income tax withholding count.

Practical 401(k) Plan Implications

401(k) plans apply deferrals and matching based on compensation as defined in the plan document, otherwise known as “eligible plan compensation.” Plan documents must specify one of the three safe harbor definitions from above and may include or exclude items as long as eligible plan compensation is not discriminatory. Typically employers have the ability to modify the definition with additional exclusions in the plan’s adoption agreement. As a reminder, all definitions exclude severance compensation which is never included as eligible plan compensation.

In other aspects of plan operations such as nondiscrimination testing and statutory limits, the plan is required to use §415(c)(3) compensation without modification. That is typically incorporated by reference in the plan’s basic plan document (not in a plan’s adoption agreement).

§414(s) Compensation (nondiscrimination testing)

• Applies to compensation used for salary deferrals in a safe harbor 401(k) plan.

• Applies to allocating safe harbor non-elective and matching contributions.

• Applies to compensation used for ADP/ACP testing

• Applies to compensation used in nondiscrimination testing under §401(a)(4)

Non-safe harbor plans may allocate contributions on any definition of compensation that satisfies §414(s) if it does not discriminate in favor of Highly Compensated Employees (HCEs). Any form of excluded compensation not excludable under any of the safe harbor definitions of compensation that automatically satisfy §414(s) requires the plan to perform the §414(s) compensation ratio test. For example, this additional testing is required to demonstrate the definition of compensation is not discriminatory where the plan excludes items such as bonuses, commissions and overtime from allocation compensation (“eligible plan compensation”).

§415(c)(3) Compensation (statutory limits)

• Applies to compensation used for §415 limits (Annual Additions)

• Applies to compensation used to determine HCEs and Key employees

• Applies to compensation used to allocate top-heavy minimum contributions

• Applies to compensation used to determine deduction limits under §404

A common plan operation error occurs when the plan sponsor includes only eligible plan compensation on the year end census data, which can lead to failures in correctly determining HCE and Key employees. All compliance testing depends on correctly identifying HCE and Key employees, which means that errors in this area could cause additional operational failures.

As a reminder, even if the plan uses a base definition of compensation that excludes certain equity compensation, that equity compensation will be counted in the compensation used to apply the statutory limits.

Employers should provide the relevant forms of employee compensation to the plan’s service provider to ensure that both the allocation of contributions is performed correctly, and the statutory limits are determined correctly.

Takeaway: Employers should review their plan’s definition of eligible compensation for deferral and employer contribution purposes to determine whether the forms of equity compensation they offer are included by default. If so, the employer should consider modifying the plan terms to explicitly exclude such equity compensation for these purposes.

Compensation Table

Practice Note: Equity compensation MUST be included when determining who is an HCE, because it is part of taxable compensation under §415(c)(3), unless it is purely capital gains.

Plan Compliance Notes for a 401(k) Plan

Timing matters because compensation for deferrals is based on when the income is paid (the pay date). This creates mismatches between payroll cycles and equity events. If the plan document does not exclude equity compensation from eligible plan compensation, Missed Deferral Opportunities and missed matching contributions or nonelective contributions may occur routinely when employees have taxable events caused by equity compensation.

Many employers chose to exclude all forms of equity compensation in the plan document (typically in the compensation section of the plan’s adoption agreement). The plan document may exclude equity compensation under the following conditions:

• It must be explicitly stated in the plan's definition of compensation.

• The exclusion applies uniformly.

• The plan passes nondiscrimination testing (or is a safe harbor plan).

Understanding the compensation definition in the plan document and how data flows from the equity platform to payroll is essential for proper implementation and administration of deferrals elections, matching contributions, and nondiscrimination testing.

Takeaway: One of the most common plan operational failures occurs where employers do not include certain forms of equity compensation as included for purposes of deferrals or employer contributions. Make sure the plan document’s compensation definition aligns with your payroll and plan practices.

Equity Compensation Summary Table

Disclaimer: This material is provided for educational purposes only and does not constitute investment advice. The information contained herein is based on current tax laws, which may change in the future. Newfront Retirement Services cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. The information provided in these materials does not constitute any legal, tax or accounting advice. Please consult with a qualified professional for this type of advice.

Conclusion

As equity compensation becomes an increasingly standard part of total rewards, its ripple effects on 401(k) operations are too significant to overlook and too nuanced to navigate without care. From RSUs vesting at inopportune times to NSO exercises inflating statutory compensation, even well-run plans can stumble if payroll, HR, and service providers aren’t aligned. The good news? With a clear understanding of how each equity type flows into plan compensation, employers can confidently safeguard compliance, avoid costly errors, and protect the participant experience. Stay curious, stay diligent, and keep following 401(k)ology as we continue untangling the complexities of modern plan administration, one topic at a time.

Newfront Retirement Services team is ready to help your organization make sense of all the regulations. Feel free to contact me or just connect to keep up to date on all things ERISA 401(k): Joni_LinkedIn and 401(k)ology

Helpful Links:

IRS Tax Topics – Stock Options

Schwab - Restricted Stock and Performance Stock Taxes: A Guide

IRS Chapter 3 - Compensation

IRS - Compensation definition in safe harbor 401(k) plans

401(k)ology – Highly Compensated Employees

401(k)ology – Safe Harbor 401(k) Plans

401(k)ology – Missed Deferral Opportunity Corrections – New Rules!

401(k)ology –“Post-Severance” vs. “Severance” Compensation

Newfront Retirement Services, Inc. is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration as an investment adviser does not imply any level of skill or training, and does not constitute an endorsement by the SEC. For a copy of Newfront Retirement Services disclosure brochure, which includes a description of the firm’s services and fees, please access www.investor.gov or click HERE for the disclosures on our website.