Definition of Compensation for Retirement Plans: How to Handle Bonuses, Commissions & More

Using the correct compensation for plan purposes is quite important. Compensation controls the amount that a participant contributes to the plan through the 401(k) provision (e.g. employee “A” elects to contribute 3% of compensation), the amount of the employer match (if any) and how much each employee receives from employer “profit sharing” type contributions (if any).
 
For almost all of the retirement plans that we administer the compensation definition is total taxable wages as it appears in Box 1 of an employee’s W-2 (taxable income) PLUS any pre-tax deductions for contributions made to the 401(k) plan, and pre-tax deductions for contributions to a cafeteria plan (Health Insurance Premiums, Flexible Spending Accounts, Dependent Care Accounts etc.). Generally, this definition works out to be “gross wages”.
 
Nevertheless, watch out for the following types of compensation which are occasionally handled incorrectly:
 

Bonuses

Each year many of our clients consider paying bonuses to their employees. One of the most common questions posed regarding compensation relates to whether the employer has to withhold 401(k) contributions from a bonus.
 
The general answer to this question is “Yes”. Employers should apply each employee’s existing contribution election to a bonus. Additionally, if an employer matching contribution applies, the employer must match the contribution made from the bonus.
 
There are only two situations that would allow the employer to pay a bonus without withholding the 401(k) contributions:
 

1. The Plan document excludes bonuses from the definition of compensation (NOTE; very few of our plans exclude bonuses from compensation).
2. The Plan document allows employees to make a special 401(k) contribution election that applies only to the bonus AND the employee completes an election form that indicates that no 401(k) withholding should be taken from the bonus.

If one of these two situations does not exist, you must withhold 401(k) contributions from bonuses and make the corresponding employer match (if any).
 

Commissions  

Cash sales or incentive commissions are compensation under our standard definition (i.e. it represents taxable income reportable on the Form W-2).
 
Employers should apply each employee’s existing contribution election to any cash sales or incentive commissions. Additionally, if an employer matching contribution applies, the employer must match the contribution made from the commissions.
 

Non-Cash Taxable Benefits 

Not many of our clients have non-cash benefits that they must report on an employee’s Form W-2. However, keep an eye out for items like taxable personal use of a company car or taxable purchase of excess life insurance benefits. If these items exist they must be counted as compensation even though they are not actually paid to an employee in cash.
 
THE BOTTOM LINE…If you ever question whether a certain form of compensation should be counted for plan purposes, please contact us and we will let you know.


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