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Avoid the most common 401k compliance error with these eligible compensation best practices

February 15, 2021

401k compliance error

Errors with eligible compensation—or, the income that counts toward your 401k retirement plan—were the number one compliance issue we saw in the 2020 audit season. 

It’s counterintuitive, because the definition of “eligible compensation” is dictated by the employer sponsoring the plan. If the policy is under the employer’s control, you’d think everyone would get the implementation right … But you’d be wrong.

Sometimes, there is a third party managing retirement plan benefits. Turnover in HR, or a long period since the benefits plan was established, can also result in the definition of eligible compensation getting lost over time.

Eligible compensation errors are so common that they show up in the IRS 401k Plan Fix-It Guide—and fixing mistakes can be costly. Don’t let a benefits plan violation happen to you!

As a best practice, we’ve recommended implementing strict, well-defined controls to make sure things don’t slip through the cracks. In this post, we’ll share exactly what those well-defined controls look like, so you can start 2021 on the right foot.

Audit your income types against your benefits plan

Eligible compensation inclusions are clearly defined in your benefits plan documents. Typically, they include things like gross wages, with adjustments for bonuses, fringe benefits, overtime, etc.

401k plans generally include one of three options for defining compensation:

  • W-2 wages
  • 3401(a) wages, or all compensation subject to federal income tax
  • 415 safe harbor, which includes pre-tax salary deferrals

All three can include or exclude specific forms of compensation, like reimbursements, overtime, or moving expenses.

Although the definitions are clear, execution can get tricky. For instance, if your plan dictates that you should calculate deferrals on W-2 wages, money paid outside of regular payroll for things like bonuses or reimbursements can have 401k deduction turned off. If the deduction isn’t turned back on for income that’s not excludable, that’s a violation.

That’s why the first step is to audit all of your company’s income types against the inclusions and exclusions outlined in your benefits plan, point by point. Make sure each compensation type is correctly flagged as eligible compensation for 401k contribution calculations.

You won’t know what compliance looks like without clarity on the rules, so review your benefits plan documents closely, and make sure your plan election forms are consistent with the plan terms.

Perform annual reviews of compensation definitions, and make sure the 401k benefits plan sponsor is trained to fully understand the benefits plan documents.

Establish controls to prevent errors

Now, set up guardrails to prevent errors in execution.

Use a checklist whenever you pay out a bonus or an “extra” check—or whenever you add new income types—to confirm whether it should be considered part of the benefit plan contribution calculation or not.

Or, simply don’t allow 401k deductions to be turned off for bonus pay (or other types of eligible compensation under your plan).

Implement a strong, clear policy, and share it with everyone who touches payroll and benefits plan management. 


If you do find discrepancies in your audit, don’t worry—we can help. Schedule your virtual appointment with Cassell Plan Audits at 630.886.7669.

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