Severance pay and deferrals

[Guest Beachgirl]

A question has come up with regard to severance pay and whether or not you can defer on it. Most of our plans are written with the definition of compensation being 3401(a) wages. After looking at the regs, this would seem to include severance pay. However, when looking at the ERISA Outline Book, it appears that deferrals are not permitted on severance pay because you are not an eligible employee (which makes sense to me) (Treas. Reg. 1.401(k)-1(e)(8) and Prop. Treas. Reg. 1.415©-(2)(e)). One thing that causes a question in my mind, though, is that 5.a. (Chapter 11 of the 2006 edition - page 11.47) says ". . .it has been the IRS' informal position that a former employee should not be treated as an eligible employee for any year in which post-termination compensation is paid but the individual is not employed for any part of the year. . . . " That makes sense when the severance pay is paid in a year other than the year in which the participant terminated, but what about when the termination date and the severance pay are in the same year? For example, an employee terminated 9/23/05 and received his final "paycheck" on the 9/30/05 payroll (this included compensation for all hours worked through his date of termination). However, he continued receiving severance pay through 12/31/05 (the "severance pay" was not on account of prior hours worked, overtime, unused vacation/sick days, etc.). He deferred on ALL of his wages, and the company matched. Was this correct? Logically, I would say no, but the regulations are not always logical . . .

Thanks for your help!

[Leopurrd]

You may want to look at the proposed 415 regulations. If your plan does in fact include severance pay (check the trust document for more info, they may be able to explain it further than the definition of compensation), then you may be able to include the first 2 1/2 months of that pay according the 415 regs....Corbel.com has a great explanation of them if you're looking for it.

Vicki

[Randy Watson]

The following Q&A took place between the JCEB and Treasury in 2000:

401(k) – Cash or Deferred Arrangement

Can an individual receive a distribution from a section 401(k) plan following termination of employment, even though the individual continues to receive payments from the employer pursuant to a severance agreement? If not, can the individual make section 401(k) contributions with respect to the payments made pursuant to the severance agreement?

Proposed Answer: The individual can receive a distribution as long as there is a bona fide termination of employment. If there has been a termination of employment, though, no further elective contributions may be made by the individual pursuant to section 401(k).

IRS Answer: The IRS agrees with the proposed answer. An employee who is no longer rendering service can receive a distribution, notwithstanding that the employer is continuing to pay the employee compensation, such as severance benefits.

[Bob R]

Not sure if the JCEB Q&A is on point. I suppose it's authority that the person is terminated - so the person is terminated for purposes of being an eligible employee.

I have no problem deferring out of the last pay check even though it may include some pure severance pay. But, I wouldn't allow deferrals out of the continued severance payments b/c the person is no longer an eligible employee.

The proposed 415 regs can be relied upon (and would require an amendment), but they wouldn't help you b/c they don't permit deferrals on pure severance pay, even if paid within 2 1/2 months.

The good news is that there is no formal IRS guidance on this other than the proposed 415 regulations. Absent the regulations, severance pay is compensation under the terms of the plan, and the only issue is whether the person is "eligible" to defer.

[david rigby]

Several prior discussion threads on this topic. Try the Search feature.