The definition of “compensation” may seem straightforward, but how it is defined for the purposes of your 401(k) plan can vary depending on the terms of your plan document. Understanding the types of compensation is important because it is used to calculate employee deferrals, matching contributions, profit sharing allocations, and perform required limit and nondiscrimination testing.
Under your Guideline 401(k) plan, compensation is defined as the amount your company pays an employee during the calendar year that is subject to individual income taxes plus any pre-tax deferrals to the 401(k) plan or pre-tax election to pay for most other benefits, such as health insurance, cafeteria plan elections and transportation spending plans. This definition can also be described as “W-2” or “gross compensation” and generally includes all compensation.
Compensation in your Guideline plan document is not something that can be customized.
What is included in compensation for 401(k) purposes
Salary
Base pay: The annual base salary of an employee.
Bonuses, commissions, and tips: If employees are paid large, irregular bonuses you may want to alert those employees of payment timing so they can plan deferrals accordingly.
Compensation earned before plan eligibility for certain purposes: Deferrals can only be made from income after an employee becomes eligible. All matching and non-elective Safe Harbor contributions will typically be calculated based on compensation earned while a participant is in the plan. Profit sharing is generally based on full plan year compensation (includes pre-entry compensation earned during the applicable year).
Post-employment: Compensation is included for work performed that is paid within the later of 2 ½ months or the end of the year of termination. Compensation paid within this time frame for services performed, including commissions and bonuses, unused accrued sick, vacation, or other leave are included. This does not include any severance payments.
Compensation over $345,000 in 2024 ($330,000 in 2023) for elective deferrals only: This amount must generally be prorated for plan years less than 12 months. Even when some of the compensation is over limits and is not included, Guideline needs total compensation for each individual (owners with self-employment income will have deductions calculated from earned income even if it is over the income limit).
Benefits & insurance
Salary reduction elections to 401(k) and qualified welfare benefit plans: Pre-tax salary elections are included in compensation. Reducing taxable wages for these elections does not reduce compensation for the 401(k) plan. These elections include those made to the 401(k) plan and any pre-tax employee contribution to a welfare benefit plan (e.g., health insurance) offered under a qualified deferral arrangement.
Taxable fringe benefits: Examples include fitness stipends and personal use of a company vehicle reported as W-2 income.
Health and accident insurance premiums paid for an S-corporation shareholder/employee with greater than 2% ownership: These are company paid premiums that are reportable as wages on the shareholder-employee's W-2.
Transportation spending plan (code section 132(f)) pre-tax elections: These elections are generally not subject to taxation but are included in compensation for purposes of the 401(k) plan.
What is excluded from compensation for 401(k) purposes
Pay from other members of a legally related group: Only compensation paid from the entity sponsoring the plan can be considered compensation for Guideline plan purposes.
Contractors’ pay: According to the IRS, independent contractors cannot participate in a 401(k) plan sponsored by one of their employers. However, they are eligible to establish their own 401(k) plans. Learn about self-employed owner or partner compensation here.
Severance pay: Income paid as part of a severance package is not considered “earned income” or considered compensation for 401(k) purposes.
Nontaxable fringe benefits: Employer-provided benefits like educational (under a dollar limit) or certain employer provided transportation benefits.
Actual expense reimbursements: Reimbursement of expenses, such as travel or office supply purchases where the actual cost is repaid.
Compensation over $345,000 in 2024 ($330,000 in 2023): For employer contributions or nondiscrimination testing purposes, compensation over the limit is not included. This amount must generally be prorated for plan years less than 12 months. Even when some of the compensation is over limits and is not included, Guideline needs total compensation for each individual (owners with self-employment income will have deductions calculated from earned income even if it is over the income limit).
*Note that under IRS rules, independent contractors cannot participate in a 401(k) plan sponsored by one of their contractors. However, they are eligible to establish their own 401(k) plan. Learn about self-employed owner or partner compensation here.
This information is intended to provide general information about the Guideline plan provisions, it is not intended to be tax or legal advice. As always, if you have specific questions about your situation you should consult your tax advisor.