A plan’s definition of “compensation” tends to be one of the trickier aspects of 401(k) administration. Having been asked multiple times in the past 12-months whether deferrals to a nonqualified deferred compensation plan need to be deducted before determining eligible compensation for 401(k) deferrals (spoiler: they do), it seems a blog post on the subject is in order.
The vast majority of 401(k) plan documents define compensation by starting with one of the following base definitions: W-2 (Box 1) compensation; Section 3401(a) compensation; or Section 415 compensation (the specifics of these base definitions are beyond the scope of this post). Each definition has its nuances with respect to whether certain types of compensation should be either included or excluded from the base definition (e.g., fringe benefits or amounts realized from the exercise of stock options).
Despite their differences, the base definitions of compensation all treat nonqualified plan deferrals the same. Each of the base definitions excludes amounts deferred to a nonqualified deferred compensation plan in the year in which the compensation is deferred. For example, if a participant earns $285,000 during a plan year and elects to defer $85,000 of it into a nonqualified deferred compensation plan, then only the remaining $200,000 is eligible compensation for 401(k) deferral purposes. If the participant was permitted to make 401(k) deferrals on all $285,000, then certain corrections may be necessary.