401(k)ology – Clawbacks - The Impact on 401(k) Plans
By Joni L. Jennings, CPC, CPFA™ | Published April 17, 2023
What the heck is a clawback? How does a clawback affect retirement plan contributions? In this blog, we will identify operational problems with incentive compensation clawbacks, review the impact on salary deferrals that have been deducted from that compensation and deposited to the plan (including associated employer matching contributions), and provide solutions to prevent operational headaches before they happen.
Generally speaking, clawbacks occur when employees fail to satisfy contractual obligations tied to cash incentives that are subject to conditions the employee must satisfy to keep the money. For example, a company may provide a sign-on bonus that is paid to the employee immediately upon hire which may be taken back if the employee does not stay employed with the company for a minimum length of time or does not achieve certain goals.
The downside to the clawback is that an employee may have already made salary deferrals into a 401(k) plan from the upfront payment of compensation. What happens if the contractual obligation is not satisfied? Can an employer get that money back? What if the payment of the compensation happens in one calendar year, but the clawback does not happen until the subsequent calendar year?
Oy vey, right?
Clawback Compensation Basics
The first concept with clawbacks is understanding that the upfront incentive payment is considered taxable income to the employee. Whether the retirement plan document defines eligible plan compensation as amounts reported on Form W2 (Box 1), Section 415 safe harbor compensation, or 3401(a) wages for withholding purposes (i.e., the three safe harbor definitions of plan compensation), the payment of the upfront compensation would by default be included for plan contributions and compliance testing. Exceptions may apply if the plan document excludes certain types of bonus/incentive compensation.
Under any of the three safe harbor definitions, the incentive payment (which is subject to the clawback) would be included in eligible plan compensation at the time of payment to the employee—unless this bonus-type of compensation is specifically excluded in the plan document. If this specific type of compensation is not excluded in the plan document provisions, employees who receive the one-time payment may elect to make 401(k) deferrals from the compensation. This of course assumes that the employee was eligible for the 401(k) plan at the time of the payment, which may not be the case for a new hire receiving a sign-on bonus upon the start of employment. However, immediate eligibility is common in larger companies that allow participation in the plan on an employee’s date of hire.
In addition to 401(k) deferrals, employers may be providing matching contributions on a per pay period basis. Employees in this situation who elect to make salary deferrals from the upfront incentive payment will likely also receive a matching contribution based on that compensation.
401(k) Plan Assets vs. Clawbacks
Once the deferrals and any associated matching contributions are deposited in the 401(k) plan, the funds are considered plan assets. While the employer who later invokes the clawback provision would like to reverse the incentive payment through payroll to “undo” everything as if it were never paid, it is not quite that simple when a qualified retirement plan is involved.
It is worth noting that the IRS regulations, which govern retirement plan operation, do not address (and perhaps did not anticipate) clawbacks of compensation. Therefore, there are no provisions contained in the regulations (or other sub regulatory guidance) that directly address or guide practitioners on how to deal with a clawback of plan assets. The fact that the contributions made from or on clawback compensation may not be worth the same amount as was originally deposited to the 401(k) plan, if there has been a downturn in the market, creates additional levels of complexity with no clear answers.
Best Practices: Before incentive compensation arrangements (only those which may be clawed back) are instituted, review the plan document to determine if the incentive compensation will be included as eligible plan compensation. Knowing whether it is included or excluded will help determine if changes to the plan’s definition of compensation should be adopted.
Clawbacks and 401(k) Contributions
To understand the impact of clawbacks on plan contributions, let’s review Bob’s situation.
Bob is hired on 2/15/2022.
The company 401(k) plan has immediate eligibility and no compensation exclusions.
Bob’s agreement with the company to keep his sign on bonus of $10,000 requires that he remain employed until 2/15/2023.
Bob elects to make salary deferrals of $5,000 from his sign on bonus.
The company provides a matching contribution each payroll period equal to 50% of deferrals on deferrals up to 10%, with a true up at year end.
Bob voluntarily leaves employment with the company on 10/15/2022.
Bob’s regular compensation is $5,000 every semi-monthly payroll period and he elects to defer 10% each pay period. Total compensation is $80,000 plus the $10,000 sign on bonus, or $90,000. His total deferrals are $8,000 from regular pay plus $5,000 from the bonus, or $13,000. The employer match deposited to his plan account is $4,500.
In early November 2022, the employer decides to clawback the $10,000, but what about the $5,000 that was deferred? What if the employer wants to process a negative payroll entry? Can they? Should they?
At the time the incentive of $10,000 was paid to Bob, the $10,000 was eligible plan compensation. Therefore, the $5,000 in deferrals were eligible to be made to the plan at the time of the payment of compensation to Bob. From an operational standpoint, there is no mechanism in any legal guidance that specifically allows a reversal of the deferral that was made in February 2022.
The same may not be true for the matching contribution, but that depends on when (or if) the employee returns the money to the employer. Assuming Bob sends the employer a personal check for $10,000 before 12/31/2022, the employer could adjust Bob’s earnings (except for the deferrals) in payroll so that his gross compensation reportable on the 2022 Form W2 reflects $80,000 in compensation. Bob’s W2 would reflect $13,000 in deferrals for 2022, but the match on $80,000 in compensation would be $4,000 rather than $4,500. The excess $500 in match is corrected by forfeiting that amount (adjusted for earnings), which the employer may use to reduce future match contributions to the plan.
If Bob does not return the $10,000 until 2023, the situation looks slightly different. Bob’s 2022 income has already been subject to ordinary income taxes and the 2022 Form W2 issued. For plan operation and compliance testing, Bob’s compensation is $90,000 in 2022 and his matching contribution would be based on that amount. Therefore, the match of $4,500 would not be adjusted and would remain in Bob’s retirement plan account. Bob should consult with his personal tax professional to determine how to recoup any tax liability from 2022 if the clawback was not returned to the employer until 2023.
Under either scenario, it should be noted that the deferrals cannot and should not be removed from Bob’s account, as the deferrals were made from eligible plan compensation at the time the payment of the sign on bonus was made.
Practical Note: HR Professionals should exercise caution when reversing compensation payments through payroll due to the complexity and impact on the 401(k) plan. Plan corrections must take into consideration any gains or losses on the account, and that may not be captured with a negative payroll adjustment.
Distribution Before Clawback
Another drawback with clawbacks is that a terminated employee may take a distribution before the employer determines that the obligation to keep the incentive compensation was not met.
Going back to the example above, Bob terminated employment on 10/15/2022 and is eligible to take a distribution from the 401(k) plan. Assuming that the matching contributions were 100% vested, when Bob takes a distribution of his account balance on 10/20/2022, it will include the additional $500 in match that was made on the $10,000 incentive payment.
The employer may be able to recoup the $500 overpayment (adjusted for earnings) if the employee repays the $10,000 in 2022. However, if Bob does not repay the $10,000 until 2023 then there is not an overpayment. To reiterate, the employer should not attempt to recoup the repayment of any deferrals that were distributed, as the deferrals were made from eligible plan compensation at the time the bonus was initially paid to Bob.
For more information on the recovery of benefit overpayments, click HERE to read the blog.
If an employer plans to utilize incentive compensation that may later be clawed back if specific contractual obligations are not satisfied, there are a few strategies that may prevent clawbacks from causing these 401(k) plan complications.
Excluded Compensation Option – Consider an amendment to the plan’s definition of eligible compensation to specifically exclude incentive-type bonus payments (or any compensation subject to a clawback clause). If the compensation which is subject to a clawback clause is never eligible plan compensation, then the 401(k) plan will not be impacted. No deferrals would be allowed from the excluded compensation and no employer contributions would be allocated upon that compensation. Note that the exclusion of this type of compensation will require additional annual nondiscrimination testing to demonstrate that the plan’s compensation definition is not discriminatory (the exclusion no longer satisfies one of the three safe harbor definitions of eligible plan compensation).
Eligibility Option – If an employer only uses clawbacks as a hiring tool (i.e., where the payment of the incentive bonus is upon hire), the plan document could be drafted to require 30 days of employment before becoming eligible for the 401(k) plan. If pre-entry compensation was also excluded, then the compensation paid upon hire date would be paid before the employee becomes eligible to participate in the 401(k) plan. Unlike the specific exclusion to compensation, this plan design does not require additional annual nondiscrimination testing. The downside is that pre-entry compensation must be tracked for all employees and reported annually so that it is excluded from employer contribution allocations and/or compliance testing (noting here that different definitions of compensation can be used for allocations versus nondiscrimination testing and that certain limits are always based on total compensation even if pre-entry compensation is excluded).
Either of these options will prevent clawback compensation from impacting the company 401(k) plan. It is worth noting that the plan’s fiduciaries should carefully consider how clawback agreements can impact the 401(k) plan’s operation. It will likely cost significantly more to correct plan qualification failures than the amount of the clawback is worth to the employer.
Best Practices: Consult with ERISA counsel, plan service providers and tax professionals to implement policies and procedures regarding clawback clauses, specifically as it relates to the impact on the company 401(k) plan.
Clawbacks may be a useful tool for an employer desiring to recruit and retain talented professionals; however, this tool may also cause operational headaches and plan disqualification concerns for the company retirement plan. There is currently no clear guidance that specifically allows retirement plan contributions to be clawed back. Therefore, our recommendation is that any employee deferrals (or voluntary after-tax contributions) made from compensation subject to a clawback should remain in the 401(k) plan. The treatment of any employer contributions will depend on if/when the compensation is paid back to the employer.
Newfront’s Retirement Services team is available to assist you with questions regarding plan operation, compliance or other retirement plan questions that may arise.
Email us at 401kHelp@newfront.com.
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Joni L. Jennings, CPC, CPFA™
ERISA Compliance Manager, Newfront Retirement Services, Inc.
Joni Jennings, CPC, CPFA is Newfront Retirement Services, Inc. Compliance Manager. Her 30 years of ERISA compliance experience expands value to sponsors of qualified retirement plans by offering compliance support to our team of advisors and valued clients. She specializes in IRS/DOL plan corrections for 401(k) plans, plan documents and plan design.