(b)lines Ask the Experts – 3401(a) Definition of Compensation

“What in the world is 3401(a) compensation? I know what W-2 wages are obviously, but how is this definition different?” 

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

First of all, the Experts commend you for reviewing the compensation definition in your plan and understanding it, since one of the most significant areas where plan defects occur is the failure to properly administer the plan’s definition of compensation.

Along with W-2 compensation, 3401(a) compensation, is one of the most common definitions of compensation found in retirement plans. Named for the Section of the Code that defines “wages” for certain purposes, Code Section 3401(a) wages are defined as compensation that is subject to federal income tax withholding at the source of the compensation. In practice, such a definition will include less 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). 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.

Section 3401(a) wages are a popular definition of compensation in retirement plans for good reason. Along with W-2 compensation, Section 3401(a) wages are an alternative safe harbor definition of compensation, meaning that this definition can be used to calculate the 415 limit as well as related compliance limits.

Of course, your plan is not REQUIRED to use a Section 3401(a) wages definition of compensation. If you feel that, say, a W-2 compensation definition is more appropriate and/or more compatible with your retirement plan operating systems, most vendor prototype plan documents (coming soon for 403(b)s) will offer W-2 compensation as an option (and, if not, there is always an option of an individually designed plan document that would include this definition). Regardless of the definition you choose, 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.

It should also be noted that other compensation definitions may apply to your retirement plan as well. For purposes of calculating the contribution limits to a 403(b) plan, for example, there is a special definition of “includible compensation” under 403(b)(3), which also allows the ability to make employer contributions for up to five years following termination of employment, a feature unique to 403(b) plans.

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.