Understanding the Definition of Plan Compensation

Jordan Cross
Oct 9
4 min read

Updated: Oct 22

Why Understanding Plan Compensation Matters More Than You Think

The definition of compensation, sounds simple, right? Well, when it comes to 401(k) plans, this is a detail that consistently trips up our plan sponsors. On the surface, all compensation equals pay, but that’s not exactly true. When you dig into how compensation is defined in the Plan Document and how it’s applied in payroll and 401(k) contributions, the picture gets much more complicated.

Misunderstanding Plan Compensation or setting up the wrong definition of compensation in payroll are some of the most common and costly errors we see in Plan Administration.

Let’s break down why understanding Plan Compensation matters, where things often go wrong, and how you can safeguard your plan.

Whether your Plan is exclusively using W-2 wages, K-1 Earnings, Schedule C income or some combination of the above, understanding the definition of compensation is foundational to running a healthy Plan.

What is “Plan Compensation” in a 401(k) Plan?

One of the oldest jokes in the TPA world is “the definition of compensation is what the client sends us,” but the reality is far more complicated. Plan Compensation isn’t just what an employee sees on their paycheck, and it isn’t just a straightforward setting in payroll. Plan Compensation is a technical definition spelled out in your Plan Document and tied directly to IRS rules, which we use in Non-Discrimination & Compliance Testing and in the calculation of Employer Contributions.

The Plan and Plan Document must specify what counts as “eligible compensation” when calculating employee deferrals, employer matches, profit-sharing contributions, and annual Non-Discrimination Testing. Common inclusions and exclusions might cover:

Base pay or salary
Bonuses and commissions
Overtime pay
Severance
Expense reimbursements or allowances
Fringe benefits

For example, one plan may say bonuses are included in compensation, while another specifically excludes them. Both are legal elections, as long as the document is consistent, and payroll contributions follow the definition precisely.

Here’s Where Things Often Go Wrong

Here’s where things often go sideways. Payroll systems may default to broad definitions, while the Plan Document requires something narrower. Or an HR or new payroll integration solution may assume that excluding bonuses is fine because “no one wants to defer from those anyway,” even though the plan says otherwise.

Common mistakes include:

Excluding compensation that should be included
- Example: Leaving out bonuses or commissions even though the plan requires them to be included for deferral and match purposes.
- Only counting compensation when a participant meets entry and eligibility, as opposed to full year compensation
Including compensation that should be excluded
- Example: Counting expense reimbursements or fringe benefits when the plan excludes them.
Inconsistent application
- Example: Treating compensation one way for employee deferrals and another way for employer match, creating mismatches in funding.

Even small errors compound quickly. If your plan fails annual Non-Discrimination Testing because of a compensation mistake, or if employer contributions are calculated on the wrong definition of compensation, the fix can mean reprocessing payroll, issuing corrective contributions, owing employees more contributions, and filing with the IRS for self correction or through a formal process.

Why This Matters

As a plan sponsor, you’re a fiduciary. That means you have a legal duty to follow the Plan Document, and that includes applying the definition of compensation consistently and correctly.

The Department of Labor (DOL) and IRS take it seriously because compensation errors affect employee benefits directly. If participants are shortchanged on deferrals or matches, they’re missing out on retirement savings they’re entitled to.

Best Practices for Getting It Right

The good news is that compensation errors are preventable. Here’s how to avoid becoming one of the cautionary tales:

Know Your Plan Document

Read the section that defines compensation. Highlight inclusions and exclusions. Share it with payroll and HR teams so everyone is on the same page.

Align Payroll and Plan Provisions

Make sure your payroll system is set up to pull the correct definition. If your plan includes bonuses but your payroll coding doesn’t, that’s a problem waiting to happen.

Audit Contributions Regularly

Don’t wait for year-end testing. Spot-check contributions throughout the year to confirm that deferrals and matches are being calculated on the correct compensation base.

Coordinate With CrossPlans

For most clients, CrossPlans is not routinely reviewing your payroll files and contribution uploads, however, we can always do a cursory review periodically. Even a 10-minute review can save months of correction later.

Communicate Changes

If your company updates pay structures, like adding new types of bonuses, changes payroll companies or adds a payroll integration tool, please remember to loop in CrossPlans right away. The plan definition may need to be amended, or payroll may need adjustments.

Final Thoughts

Understanding your plan’s definition of compensation isn’t glamorous, but it’s critical. It’s the foundation for accurate contributions, fair testing, and protecting your fiduciary responsibilities.

If you’re a plan sponsor, don’t assume payroll “has it covered.” Confirm that what’s in your Plan Document is what’s being used in practice. Aligning those two is one of the simplest, most effective ways to keep your plan healthy and your employees’ retirement savings on track.

Dana Point, CA

714.210.4164

info@crossplans.com

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance or tax/legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation.