Problem With Compensation Definition in 403(b) Prototype Plan

“Our issue is that the base plan document only allows for a modified W-2 definition of compensation, that adds back deferrals to 403(b), 457(b) etc. plans, but otherwise includes all other forms of W-2 comp, and does not specifically exclude employee benefit payments.

“We maintain a 457(b) plan, and, of course, distributions from that plan are W-2 income. The base plan document does not exclude such distributions from compensation. Our adoption agreement does permit us to modify the base plan document definition of compensation, but it currently does not exclude 457(b) distributions. Should they be excluded?”

Stacey Bradford, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, vice president, Retirement Plan Services, Cammack Retirement Group, answer:

Good question, as this points to some of the limitations that certain recordkeeper-provided documents can have, which can result in operational failures unless the base plan document is read closely in conjunction with the adoption agreement. Having said that, it is unusual, but obviously not unheard of, for a vendor-provided base plan document to limit plan compensation to one particular type. Most provide a selection from several types of compensations (such as 415 compensation, W-2, or 3401(a) wages subject to withholding) and options to include or excluding various types of compensation in order to avoid issues such as the ones you describe. They may also provide different options for elective deferrals than for employer non-elective contributions.

Fortunately, in your case, it is rare for a current employee to receive a 457(b) distribution, and normally you would not need to include such compensation as plan compensation on the basis that the individual is no longer an employee. However, if your 457(b) plan permits in-service distributions in the event of an unforeseeable emergency, the default rule is that they are not considered compensation that can be the subject of elective deferrals, but you could certainly amend your adoption agreement to expressly exclude (or include) 457(b) distributions from your plan’s definition of compensation for purposes of permitting 403(b) deferrals from such distributions, since they are nonqualified plan distributions. The source for this is in the 415 regulations, which state that “any distributions from a plan of deferred compensation (whether or not qualified) are not considered as compensation for section 415 purposes, regardless of whether such amounts are includible in the gross income of the employee when distributed.

However, if the plan so provides, any amounts received by an employee pursuant to a nonqualified unfunded deferred compensation plan are permitted to be considered as compensation for section 415 purposes in the year the amounts are actually received, but only to the extent such amounts are includible in the employee’s gross income.”  Generally, only compensation as defined in section 415(c)(3) and 1.415(c)-2 can be made subject to elective deferrals. (The definition for purposes of employer non-elective contributions could be different.)  And, while you’re taking that action, you should examine all of your current pay codes to determine if they are consistent with your plan’s compensation definition.  

The Experts have seen countless examples of plan defects where a plan sponsor failed to properly read/interpret a recordkeeper’s base plan document in conjunction with its adoption agreement. Hats off for you for catching this issue and avoiding a potential operational failure down the line!

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.