Plan compensation is one of the most difficult topics in understanding retirement plan operation. The topic can be confusing for both human resource professionals and retirement plan practitioners. This blog will review compensation that is paid to an employee upon separation from service with the employer.
Plan Compensation Basics
Before diving into categories of compensation paid after an employee terminates employment, let’s review some compensation basics. There are three base definitions of compensation used as the starting point in qualified retirement plans:
- Form W-2 Compensation (Box 1)
- Section 415 Safe Harbor (Gross compensation including pre-tax deferrals)
- Section 3401(a) Wages (Compensation subject to Federal tax withholding)
The Form W-2 wage definition is commonly used for plan allocation purposes because it can be readily obtained. If using either the Form W-2 or the 3401(a)-wage definition, plans typically add back pre-tax deductions that reduce the amounts reported in Box 1 to arrive at gross compensation. Any of the above definitions can be further adjusted by including or excluding some post-severance (post termination date) compensation.
Best Practices: Elect a definition of eligible plan compensation that your organization will be able to easily support.
Severance Pay: “Go Away Pay” is Never 401(k) Eligible Compensation
The key distinction between severance compensation and post-severance compensation is that true severance compensation is never eligible plan compensation. I like to refer to true severance compensation as the “go away pay.” Simply put, the employer is paying the employee a stated amount of money over a specific period NOT to work for the employer. Severance compensation is not payment for services performed by that employee and is always excluded from eligible plan compensation.
“Go away pay” is simply a shorthand phrase to distinguish between severance compensation and post-severance compensation. According to the Department of Labor, “Severance pay is often granted to employees upon termination of employment. It is usually based on length of employment for which an employee is eligible upon termination… and is a matter of agreement between an employer and an employee (or the employee’s representative).”
The distinction is that severance pay is not based on services performed by the employee nor would it have been paid to the employee had the employee remained an employee of the employer. Severance pay is typically associated with a layoff or dismissal (not a temporary furlough). This type of compensation is never eligible plan compensation. Therefore, employee deferrals may not be withheld from severance pay and employer contributions may not be allocated on severance pay.
Severance Pay: What About When It’s Paid Pre-Termination of Employment?
Recently, we have seen a trend in severance compensation being paid to an employee before the last day of service performed by the employee. The regulations are very clear that true severance pay (generally paid after an employee is dismissed from service with the employer), is never eligible plan compensation. There are different applications for compensation in retirement plans. For example, the compensation used for the contribution basis (allocations) may be different from compensation that is used in the nondiscrimination testing. Specific definitions apply in determining who is a highly compensated employee that are not the same as the definition used for allocations.
How the pre-paid severance compensation is treated in your retirement plan will depend on the base definition of compensation specified in your plan document and specific inclusions or exclusions elected in that document. Pre-paid severance is not defined in the regulations, and there are differing opinions in the industry as to whether this compensation is a “bonus” rather than severance compensation. If the intent is to include (or exclude) the pre-paid severance compensation for purposes of your retirement plan, you will need to make sure that your plan document is very clear as to that election so as not to create operational failures applicable to deferrals and employer provided contributions.
Best practices: Consult with your plan document provider and ERISA legal counsel regarding compensation that is intended to be severance compensation. Ultimately, it is the plan sponsor’s responsibility to ensure that the plan’s definition of compensation is clearly defined, does not discriminate in favor of highly compensated employees, and is uniformly applied to all employees.
Post-Severance Pay: Regular Pay After Termination May Be 401(k) Eligible Compensation
On the other hand, post-severance compensation is compensation paid to an employee after the employee’s termination of employment with the employer. In many cases, the compensation is paid after termination because of a short timing issue due to the employer’s payroll cycle. In some cases, such as bonuses and commissions, the pay is regularly scheduled for distribution at certain points of the year, which may occur post-termination. This type of post-severance compensation may be eligible 401(k) compensation.
Post-severance compensation is eligible compensation if it meets the timing restrictions and is an amount paid to an employee for "regular” pay for services. “Regular” pay is compensation that would have been paid prior to termination had the employee continued employment with the employer. For example, an employee terminates on March 21st and the next payroll date is not until March 31st. The amount paid on March 31st is compensation earned before the employee terminated employment but is paid after date of termination.
“Regular” pay includes hourly wages, salary, overtime, bonuses, commissions, and other regular payments that the employee would have been paid had there been no termination of employment.
There is a payment timing requirement for post-severance compensation which will determine whether the post-severance regular pay is eligible plan compensation (i.e., eligible for deferrals and other employer contributions). The post-severance compensation must be paid by the later of:
- 2.5 months after termination of employment, or
- the end of the limitation year in which the employee terminated employment (in most plan documents the limitation year is the same 12-month period as the plan year).
Note that for a calendar plan year, the 2 ½ month period will be relevant only for terminations after mid-October.
Irregular post-severance compensation is not required to be included in eligible plan compensation and is subject to the same timing requirements as regular post-severance compensation. Irregular post-severance compensation includes items such as unused vacation or sick pay (PTO) and amounts paid from a deferred compensation plan. The provisions in the plan document will indicate which irregular post-severance payments will be included or excluded. It is important to understand what items are included because the compensation may be subject to salary deferral elections and employer contributions.
Severance and Post-Severance Pay Case Studies – Calendar Plan Year
Case #1 – Severance Pay
Frank has been an employee of Big Tech for more than 10 years. Unfortunately, Big Tech is reorganizing the company and Frank will be dismissed on November 17, 2022. Big Tech and Frank reach a severance package agreement that states Frank will receive an amount equal to 6 months of his salary after November 30, 2022. Because this is true severance pay, the compensation will not be eligible for any retirement plan contributions. Frank may not elect to make salary deferrals from the severance compensation and will not receive any employer contributions on the severance compensation.
Case #2 – Pre-Paid Severance Compensation
Same facts as in Case #1, except that Big Tech includes 6 months of Frank’s salary on his November 15, 2022 paycheck. Is this eligible plan compensation? Well, it depends. Big Tech should review the terms of the plan document to determine if severance compensation paid before termination is specifically addressed and whether it is included or excluded for plan purposes. If the plan document is silent, could the additional compensation be treated as a bonus? Are bonuses included (default position) or excluded (explicit in plan terms)? In this scenario, Big Tech should ensure that the plan document is carefully drafted to not leave any ambiguity regarding pre-paid severance compensation. Big Tech may have intended to count this payment as severance compensation (which is excluded for plan purposes); however, the IRS could disagree with that classification upon audit if it was not clearly spelled out in the plan document.
Case #3 – Post Severance Compensation
Same facts as Case #1, except that Frank is not offered a severance package and his final paycheck will be issued on November 30, 2022. His final paycheck will include his unused vacation and sick pay and the amount he earned before terminating employment. Are all amounts included on his final paycheck considered eligible plan compensation? The compensation that is attributable to amounts he earned for his services is always counted as plan compensation. Whether the amounts paid to Frank attributable to his unused vacation and sick pay are counted will depend on the specific plan provisions.
Case #4 – Post Severance Compensation Timing
Same facts as Case #3, except that Frank is a commissioned sales employee. He receives his final regular paycheck on November 30, 2022 but his commissions will be paid monthly after that date. Any commission checks paid on or before February 2, 2023 (2.5 months after his date of termination) would be eligible plan compensation (assumes that plan compensation does not exclude all commission payments). Any commission payments paid after February 2, 2023 would be excluded because they were not paid within 2.5 months following termination and were not paid before the end of the plan year in which he terminated.
Case #5 – Post Severance Compensation Timing
Same facts as Case #4, except that Frank terminates employment on February 15, 2023. Frank continues to receive commission payments through December 31, 2023. If the plan document does not exclude commissions from eligible plan compensation, any payments of commission paid to Frank through December 31, 2023 would be eligible plan compensation because they are paid by the end of the limitation year (calendar year 2023) that includes his date of termination.
Note: Compensation is a plan document provision and may vary from plan to plan. It is extremely important that the plan sponsor know and understand the compensation definition in its plan document. The application of eligible plan compensation is one of the most common mistakes in plan operation and requires plan correction pursuant to EPCRS if misapplied.
All contributions provided in an employer sponsored retirement plan are related to compensation paid to the employees. Therefore, it is critically important that plan sponsors and their human resource professionals understand the definitions applicable to their specific retirement plan. Understanding and following the rules will keep the plan in operational compliance. Newfront’s Retirement Services team is available to assist you with questions regarding complex compensation matters or other retirement plan questions that may arise.
Email us at 401kHelp@newfront.com
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