While most Plan Sponsors can tell you off the tops of their heads what their Plan’s eligibility requirements are, the formula for calculating employer contributions and the types of withdrawal features in their Plan; many can’t tell you what their plan’s definition of “Compensation” is.  Using the wrong definition of compensation to determine contributions is among the top 5 most common mistakes Plan Sponsors make in operating their retirement plan according to the IRS.

Did you know a plan document can have multiple definitions of compensation? One definition of compensation can be used to calculate salary deferrals while another can be used to calculate employer contributions. For example, a plan may allocate matching/discretionary contributions based on the employee’s base compensation only, while salary deferrals may be based on all forms of compensation (bonuses, overtime, etc.).  If the wrong amount of compensation is used to determine contributions, the contributions will be incorrect which may cause an operational failure (failing to follow the terms of the plan in its operation).

So what can you do to determine the likelihood of audit trouble? 

Review your plan document to understand what definition(s) of compensation have been chosen.  If possible, simplify the definition and use the same definition for all purposes. You may want to change your definition of compensation while the required plan restatements are being prepared.

Check with your payroll vendor to confirm they are using the right codes when calculating contributions. Confirm that they are applying the 401(a) (17) compensation limits ($260,000 in 2014 and $265,000 in 2015) for all plan purposes.

If you find you have used the wrong definition for calculating contributions, the error can be self-corrected without IRS approval, if it is found and corrected within two years. If 2 years have expired, you can follow EPCRS. Corrections should put participants where they would have been had the correct definition been used.