(b)lines Ask the Experts – What Is ‘Includible Compensation’?

“Our hospital sponsors a 403(b) plan, but I must admit that I am unfamiliar with the term. Can you explain what ‘includible compensation’ is?” 

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

A participant’s “includible compensation” is often used to determine employer contributions to a 403(b) plan. This is because includible compensation is used when testing annual additions (i.e., contributions) to a participant’s 403(b) contract for a year against the annual dollar limit under Internal Revenue Code (IC”) section 415(c). For example, the annual dollar limit for 2016 was the lesser of $53,000 or 100% of the participant’s “includible compensation.” A participant’s includible compensation equals the compensation received from the employer that is includible in the participant’s gross income for Federal income tax purposes for the participant’s most recent period that is a year of service (described below).

Includible compensation also includes any pre-tax deferrals under a cafeteria plan under IRC section 125, a qualified transportation plan under IRC section 132(f)(4), a cash or deferred arrangement under IRC section 403(b) or 401(k), an eligible deferred compensation plan under IRC section 457(b), or a simplified employer pension plan or simple retirement account; but excludes compensation received when the employer is not eligible to maintain a 403(b) plan.

In addition, community property laws are not taken into account when determining includible compensation. For example, a participant’s includible compensation for a year is not reduced by his spouse’s share of compensation from his employer under a state community property law. Also, a former employee is treated as having monthly includible compensation for purposes of the limit on employer contributions made to a 403(b) plan on behalf of the former employee for the remainder of the employee’s taxable year in which termination of employment occurred, and the next five taxable years. Monthly includible compensation equals one-twelfth of the former employee’s includible compensation during the former employee’s most recent year of service.

Includible compensation also does not include mandatory employee contributions to a 403(b) plan that are often a condition of employment or required by statute or contract. They might also be a condition for receiving an employer contribution. As the name implies, mandatory contributions are not considered elective deferrals under IRC section 403(b) and, therefore, are not taken into account for purposes of the IRC section 402(g) annual dollar limit on a participant’s pre-tax deferrals or as compensation for purposes of the IRC section 401(a)(17) compensation limit and or the 100% compensation limit on annual additions under IRC section 415(c). 

An employee’s or former employee’s year of service is based on the employer’s annual work period. For example, a university’s work year is the academic year. An employee who works on a full-time basis for the employer’s work period is credited with one year of service. If an employee worked full-time for part of the year, a fractional year of service is credited based on the ratio of the period of time the employee worked full-time to the period of time that is the employer’s annual work period. A part-time employee is also credited with a fractional year based on the ratio of work performed to the work performed by a full-time employee for the same annual work period. In an example from the 403(b) regulations, a professor teaches one three-credit class for one semester each school year when the typical class load for a full-time professor is nine credits in an academic year. The professor is credited with one-sixth of a year of service (3/9 credits x ½ work period = 1/3 x ½ = 1/6 of the work period). If he continued to teach only that one class, it would take him six school years to earn a year of service. His includible compensation for those six school years would be aggregated to determine his includible compensation for that year of service.

In another example, an individual worked half-time as a clerk in a hospital for 2015 and 2016, earning $25,000 per year, and retired December 31, 2016. The individual is credited with a full year of service for 2015 to 2016. Therefore, his includible compensation for each of 2015 ($25,000) and 2016 ($25,000) is aggregated to determine his includible compensation for his last year of service of $50,000. If the employer makes a contribution on his behalf for 2017, the 415(c) limit would be $50,000 (the lesser of the indexed annual dollar limit of $54,000 or 100% of his includible compensation for the last year of service).

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.