Compensation - The Backbone of Retirement Plan Testing

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1 Compensation - The Backbone of Retirement Plan Testing Robert M. Richter, J.D., LL.M. VP FIS Relius 3 Definitions 415 Compensation 415 limits Top-heavy minimums 414(s) Compensation Nondiscrimination testing Typically not defined in the plan document Plan Compensation Benefits/allocations 2 1

The Foundation 415 Compensation 3 415 Compensation 4 alternatives: Federal

(referred to as current income) Simplified alternative of current income For

2 The Foundation 415 Compensation Compensation 4 alternatives: Federal Income Tax Withholding Reportable W-2 Compensation 415 Regulatory Definition (referred to as current income) Simplified alternative of current income For self-employed (including partners) must use Earned Income (we will not cover) 4 2

3 415 Simplified Definition* Excludes Taxable fringes (IRS Publication 15-B) Taxable moving expenses Taxable nonqualified options Taxable property under IRC 83(b) 457(f) and amounts under 409(A) Compensation Must add back elective deferrals, cafeteria plan contributions and qualified transportation fringes For self-employed (including partners) use Earned Income (we will not cover) 6 3

4 Definitional Differences Received from unfunded nonqualified plan Tips Fringe benefits includible in income Accident & health plan (if taxable) Current Income Income Tax Withholding W-2 Out* In In In Generally In. Noncash Out. Tips < $20/month Out. In Mostly In In Out* Generally In. Self-insured medical Out. In Moving expense reimbursement Out* Out if deductible In 7 More Differences Current Income Income Tax Withholding W-2 Group term life insurance > 50K Nonqualified stock option exercise Qualified stock option exercise Nonqualified option when granted In Out In Out In In Out Out Out Out* In In 83(b) election Out* In In 8 4

5 415 Compensation Must add back elective deferrals, cafeteria plan contributions and qualified transportation fringes For self-employed (including partners) use Earned Income (we will not cover) 9 Post-Severance Compensation 415 Regulations set forth what must be included, what may be included, and what can t be included Limit on how long post-severance compensation can be included: 2 ½ months after severance The end of the limitation year including the date of severance Limit does not apply to disability payments 10 5

6 Post-Severance Compensation Must include regular pay May include: Leave cash-outs (e.g., cash-out of unused vacation) Nonqualified unfunded deferred compensation May not include severance pay 11 Related Employers Related employers = Controlled group of corporations or affiliated service groups Must aggregate all pay from all related employers 12 6

Compensation for Nondiscrimination Testing IRC 414(s) 13 414(s) Safe Harbors 415 compensation (any of the base definitions) Can be gross or net of elective deferrals (all or none)

7 Compensation for Nondiscrimination Testing IRC 414(s) (s) Safe Harbors 415 compensation (any of the base definitions) Can be gross or net of elective deferrals (all or none) Can exclude: Reimbursements or other expense allowances, Fringe benefits (cash and noncash) (IRS Publication 15-B), Moving expenses, Deferred compensation, and Welfare benefits 14 7

8 What is a Fringe Benefit? Achievement awards Athletic facilities Country club dues Cell phones Group-term life insurance Health coverage Meals Retirement planning services 15 Other Safe Harbor Adjustments Can exclude military differential pay (IRS Notice ) Not clear if all post-severance payments can be excluded as a safe harbor adjustment 16 8

Include/Exclude Deferrals Pat and Chris both earn $100,000 and each defers $10,000 but Pat s is pre-tax and Chris is Roth 414(s) regulations permit exclusion of amounts excluded from income due to

9 Include/Exclude Deferrals Pat and Chris both earn $100,000 and each defers $10,000 but Pat s is pre-tax and Chris is Roth 414(s) regulations permit exclusion of amounts excluded from income due to 401(k) Sponsor elects to not include these amounts Pat s compensation is $90K What is Chris compensation? (s) Alternative Definitions Must be reasonable Must pass compensation ratio test annually 18 9

Compensation Ratio Test Compare the percentage of total compensation included for the NHCEs with the percentage included for the HCEs The HCE percentage cannot exceed the NHCE percentage by more than

10 Compensation Ratio Test Compare the percentage of total compensation included for the NHCEs with the percentage included for the HCEs The HCE percentage cannot exceed the NHCE percentage by more than a de minimis amount Informally <3% is de minimis 19 Apply Limit After Other Adjustments First determine Compensation without regard to 401(a)(17) limit Then apply the limit Example: Plan defines compensation as W-2 compensation minus bonus David s gross pay was $300,000 and he had a $10,000 bonus His 2018 compensation limit is $275,000 (lesser of $275,000 or $290,000) His inclusion ration for 414(s) testing is 100% 20 10

11 414(s) and Earned Income Earned income is exclusive basis for 414(s) compensation of self-employed No alternative definition If the plan uses an alternative definition of compensation for common law employees, then plan must adjust earned income Multiply earned income by NHCE compensation ratio 21 Example Plan excludes bonuses and inclusion ratio for NHCEs is 90% Cathy s earned income is $300,000 For 2018 the plan must limit Cathy s compensation to $247,500 $275,000 (EI limited to 401(a)(17)) x 90% = $247,

12 Annual Limit on Compensation IRC 401(a)(17) 23 Limit Prorated for Short Period Prorate for determination period of less than 12 months Determination period is a plan level definition Do not prorate limit for a part-year participant if plan uses compensation while a participant 24 12

New Plan Problem Employer wants to begin elective deferrals 6/1/2018 Employer wants profit sharing allocation based on full year comp (i.e., does not want to prorate 401(a)(17) limit) Can be plan be designed to accomplish this?

13 New Plan Problem Employer wants to begin elective deferrals 6/1/2018 Employer wants profit sharing allocation based on full year comp (i.e., does not want to prorate 401(a)(17) limit) Can be plan be designed to accomplish this? 25 Solutions Make effective date of plan 1/1/2018 with special effective date for deferrals (6/1/18) Make effective date of plan 6/1/2018 and measure compensation for allocation purposes as the CY ending within the PY For PS contribution, do not exclude compensation prior to date of entry No issue for 415 compensation because there isn t a short limitation year 26 13

Annual Limit If there is a plan imposed limit on deferrals or matching contributions, the 401(a)(17) is not required to be pro-rated Example: Plan has monthly match of 100% of deferrals up to 4% of

14 Annual Limit If there is a plan imposed limit on deferrals or matching contributions, the 401(a)(17) is not required to be pro-rated Example: Plan has monthly match of 100% of deferrals up to 4% of compensation Mary defers 4% of her monthly compensation of $50,000 Match for 2018 cannot exceed 4% X $275,000 = $11,000 If plan does not apply pro-rated limit Mary s deferrals and match are $2,000/month In June she will have received maximum matching contribution 27 Putting the Definitions to Work 28 14

15 Uses of 415 Compensation Gross, full-year compensation Primary uses: IRC 415 limits IRC 416 (top-heavy) IRC 414(q) (HCE determination) 5% gateway for cross-testing (401(a)(4) regulations) IRC 404 Compensation limit for deductions (s) compensation Primary uses: IRC IRC 401(a)(4) and (5) nondiscrimination testing ADP and ACP testing ADP/ACP test safe harbors (except cannot exclude compensation above threshold) 30 15

Special Rules For 401(a)(4) For nondiscrimination purposes, determination period can be: 414(s) Compensation for plan year 414(s) Compensation for specified 12 month period ending in plan year May

16 Special Rules For 401(a)(4) For nondiscrimination purposes, determination period can be: 414(s) Compensation for plan year 414(s) Compensation for specified 12 month period ending in plan year May exclude 414(s) Compensation while not a participant 31 Cross-tested Gateways For 5% gateway, must use 415 compensation For 1/3 gateway may use same definition used to compute the HCE allocation rates For both gateways a plan can exclude compensation while not a participant 32 16

ADP/ACP Testing Compensation For ADP/ACP testing, determination period can be: 414(s) Compensation for plan year 414(s) Compensation for calendar year May exclude compensation while not a participant

17 ADP/ACP Testing Compensation For ADP/ACP testing, determination period can be: 414(s) Compensation for plan year 414(s) Compensation for calendar year May exclude compensation while not a participant ADP Safe Harbor - Compensation cannot exclude compensation over a limit other than 401(a)(17) 33 Consistency Plan must use same definition for all employees in applying a particular provision Can use different definitions for different purposes (e.g., ADP test vs. general 401(a)(4) test) Can change definition from year to year Can use different definitions in different plans as long as not aggregating for testing 34 17

18 Allocations/Benefits A plan can use any definitely determinable definition of compensation, including an unreasonable or clearly discriminatory definition, to allocate employer contributions The plan must test for 401(a)(4) nondiscrimination based on a nondiscriminatory definition of compensation 401(a)(17) limit applies 35 Effect of Discriminatory Definition Employer A s Profit Sharing Plan defines compensation as W- 2 compensation less overtime The plan allocates to each participant 20% of compensation Compensation ratio test results: Pass Plan is uniform allocation safe harbor plan Fail Plan must pass general nondiscrimination test 36 18

Safe Harbor 401(k) Plan Plan provides for SH match of 100% of elective deferrals up to 4% of compensation Compensation is W-2 wages excluding bonuses For 2018 the definition does not satisfy 414(s)

19 Safe Harbor 401(k) Plan Plan provides for SH match of 100% of elective deferrals up to 4% of compensation Compensation is W-2 wages excluding bonuses For 2018 the definition does not satisfy 414(s) (higher inclusion ratio for HCEs) How do you correct? 37 Elective Deferrals General rule: Plans have flexibility in determining what compensation is eligible for deferrals 1.401(a)(4)-4(e)(3) provides that the rate of elective deferrals permitted must be nondiscriminatory and a rate is based on compensation regardless of whether it satisfies 414(s) 38 19

Exception ADP Safe Harbor plan can limit compensation an employee can defer to a reasonable definition of compensation (no compensation ratio test) QACA Regulations provide that compensation for

20 Exception ADP Safe Harbor plan can limit compensation an employee can defer to a reasonable definition of compensation (no compensation ratio test) QACA Regulations provide that compensation for purposes of determining default contributions means safe harbor compensation as defined in 1.401(k)-3(b)(2) 414(s) except cannot exclude comp over $ limit 39 Gross vs Net Compensation Always use gross compensation (i.e., do not exclude deferrals) for deferral purposes Pete elects to defer 4% of plan compensation if net is used then how do you determine his deferral? 40 20

Matching Contributions Best Practice use the same definition of compensation for matching contributions that you use for elective deferrals Plan has 100% match on deferrals up to 4% of compensation

21 Matching Contributions Best Practice use the same definition of compensation for matching contributions that you use for elective deferrals Plan has 100% match on deferrals up to 4% of compensation Match is based on net compensation and deferrals are based on gross compensation Pete elects to defer 4% of gross compensation but will not receive a match on all deferrals 41 Irregular Compensation Irregular compensation can result in operational errors with respect to deferrals Suppose plan does not exclude bonuses for deferral purposes A participant has elected to defer 3% of compensation What happens with respect to a bonus that is paid? No deferral taken out unless special election is made 3% is taken out unless special election is made 3% is taken out because no special election is permitted 42 21

22 Other Irregular Compensation How do you handle cash tips that are reported? How do you handle the spot bonus (e.g., a gift card) or a surprise holiday bonus? 43 22

Compensation Quandary

Compensation Quandary Robert M. Richter, FIS Relius Avannesh K. Bhagat, IRS Robert M. Richter, FIS Relius Robert M. Richter, JD, LL.M. is a Vice President with FIS (formerly SunGard) in Jacksonville, Florida.