Ask the Experts – Reasons for Certain Retirement Plan Definitions of Compensation

“I recently read your Ask the Experts column about the differences between 3401(a) “pay stub” compensation and W-2 wages as a retirement plan definition of compensation. I was hoping the Experts could elaborate as to why an employer would choose one over the other? I understand this may have to do with the other benefits the employer may offer to his/her employees.”

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

Certainly! As the column points out, these definitions are two of the more popular definitions plan sponsors use as their definition of compensation for retirement plan purposes, though it is possible to utilize other definitions as well. The primary difference between the two definitions is that 3401(a) compensation will include fewer pay codes than a W-2 compensation definition, because wages subject to withholding are generally only those wages included on an employee’s pay stub (in fact, 3401(a) compensation is sometimes known as “pay stub” compensation, as you labeled it in your question). Thus, compensation items that do NOT appear on an employee’s paystub but are included in year-end W-2 reporting, such as the taxable cost of group term life insurance in excess of $50,000, are NOT included in Section 3401(a) wages.

As you indicated, the decision as to which definition to use (or an alternate definition) would be somewhat dependent on the types of other benefits an employer may offer to his/her employees. If any employer does NOT offer any benefits that would not be listed on an employees pay stub, but would be listed on the year-end W-2 if offered (such as, for example, group term life insurance), then it is probably irrelevant as to which definition is used; just choose the one that is easier to administer for the entity that is calculating contributions to the plan. If the employer does have a lot of items that are added to the W-2 that are not present in “pay stub” compensation, it might be easier to communicate a 3401(a) “pay stub” definition of compensation, since contributions will correspond to employees’ pay stubs.  However, as noted, there are other factors which should be considered when making that determination.

Regardless of the definition chosen, someone should regularly review all of your pay codes to confirm that each pay type is properly included/excluded from the plan compensation definition, based on the definition of compensation that is being used.

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.