Overtime Compensation in 401(k) Calculation

[Guest kp]

A company excludes overtime earnings from its 401(k) calculations, but includes overtime for purposes of discrimination testing and determining HCEs. Is this appropriate?

[Guest Beavis]

It can be appropriate.

Determination of HCEs has to be based on gross compensation. The plan will define what compensation is for the purposes of discrim testing and allocation of contributions.

If a non-safe harbor definition of comp is used for allocating contributions, the employer must demonstrate that the definition of compensation used is not discriminatory. Excluding overtime does not fall within the safe harbor definition of comp.

As long as a non-discriminatory compensation test is performed each year, everything should be ok.

[Guest dlm]

We had a Plan that was set up this way, but it never seemed to pass non-discrimination, because no HCE's had overtime compensation and several NHCE's had overtime compensation.

The question is how much of gross comp are you using for the benefit. The HCE Gross Percent of comp used compared on average for HCE's to the NHCE percent of gross comp used on average for NHCE's must only be different by a de minimus amount..Are question was always, what is de minimus???

It can be a tricky plan design - the mix of ee's must be just right!

[david shipp]

It is important to note that there are two definitions of compensation that can come into play here – compensation used to determine what the salary deferral is and compensation that is used to perform the ADP/ACP test. They can be different.

The requirement that compensation be nondiscriminatory under 414(s) only applies to ADP/ACP testing compensation. Following is a portion of the 414(s) 1991 final reg preamble dealing with deferral compensation:

"7. Availability of elective, employee, and matching contributions.

The temporary regulations contained a rule providing that, for the limited purposes of applying the nondiscriminatory availability requirements of the proposed regulations with respect to elective, employee, and matching contributions, any reasonable definition of compensation was treated as nondiscriminatory. This rule was deleted from the final regulations because the final section 401(k) and 401(m) regulations published in the Federal Register on August 15, 1991, and the final section 401(a)(4) regulations issued simultaneously with this regulation, clarify the application of the nondiscriminatory availability requirement under section 401(a)(4) to arrangements subject to sections 401(k) and 401(m), and make this rule unnecessary. See §1.401(k)-1(a)(4)(iv) and §1.401(m)-1(a)(2). Under these rules, employee, elective, and matching contributions are not required to be based on compensation determined under a definition that satisfies section 414(s). Rather, use of different definitions of compensation for purposes of the right to employee, elective, and matching contributions are treated as different benefits, rights, and features, each of which must separately satisfy the nondiscriminatory availability requirement of §1.401(a)(4)-4. In addition, employee, elective, and matching contributions that use a definition of compensation that has the effect of restricting access by nonhighly compensated employees may not satisfy the nondiscriminatory availability requirement of the final section 401(a)(4) regulations, even where the same definition of compensation is used for all employees.”

This doesn’t negate that fact that ADP/ACP testing compensation must satisfy 414(s), it just points out that different definitions can be used for the two purposes assuming the deferral compensation definition meets 1.401(a)(4)-4. This is likely if the same definition of deferral compensation is applied to all participants. (It could be argued that excluding overtime for HCEs has no meaning and thus would run afoul of (a)(4)-4. Based on the last sentence of the preamble above, I think this would come down to a “smell” test that would give sufficient latitude in the normal situation.)

Where the testing compensation definition is greater than the deferral compensation definition for NHCEs, however, it will make the ADP/ACP tests harder to meet.

[Guest kp]

Beavis,

Why do you say that including overtime does not affect the ADP/ACP testing average for the NHCEs?

ADP = (sum of ees "actual deferral ratios")/

(number of ees in the group)

"actual deferral ratio" ("ADR") = ("elective contributions") / ee's compensation

"elective contributions" ("EC") are the amounts that the ee actually defers, which will be higher if they are allowed to include overtime in their 401(k) calculation

Method which excludes OT:

comp %election EC ADR

50K 10% 5K 10%

Method which includes OT:

comp + OT %election EC ADR

50K + 5K 10% 5.5K 11%

Therefore, excluding overtime earnings from the 401(k) percentage election decreases their EC, which in turn decreases their ADR, which in turn adversely affects the ADP testing.

[Guest kp]

What do you mean how much of gross compensation am I using for the benefit?

Company is concerned about passing the discrimination testing. (Higher paid HCEs may not be as concerned since they are participants in the non-qualified plans.)

401(k) deduction: calculated on all gross except overtime.

Determining HCE status and performing discrimination testing: compensation using pre-1998 415©(3) definition which includes overtime earnings.

All other compensation between between the 401(k) calcution and the discrimination testing is the same.

The only difference is that the overtime earnings are not included in determining the 401(k) calculation, but it is included in determining HCE status and discrimination testing.

If we assume, that on average, the NHCs have more overtime earnings than the HCEs, how will this affect our discrimination testing? Company is concerned that including overtime in the 401(k) deduction calculation will increase its share of the match. (Have not ruled out the safe harbor match at this time).

Some background: The 401(k) deduction is in its basic form a flat amount, not a percentage of compensation. I say that because the deduction is based on the rate of pay (which is a fixed amount until the EE gets a raise), and does not include overtime. Ex: I get paid $500 dollars a week, defer 10% to 401(k), and take 2 days off without pay. My gross for that week is $300 (worked 3 out of 5 days), but $50 comes out in 401(k) as opposed to $30. Even though I'm calling it a percentage, in actuality, it's really working like a flat dollar deduction per pay.

Any comments, suggestions, issues that I have not thought of?

[Guest Beavis]

As far as the ADP/ACP testing goes, excluding or including overtime will not affect what the average for the NHCE group is. If an employee is deferring 10% of non-overtime pay, they would still be deferring 10% of pay of you did include overtime. Either way, this participant is counted at 10% in the ADP test.

The company is very likely correct in postulating that by including overtime in compensation will increase the amount of match that they will have to fund.

The issue that we were refering to in the previous posts was that you have to prove that the definition of comp used is not discriminatiory. That is a completly different test.

I'm not sure about the 401(k) test, but the comp that you use in performing the 401(m) test must satisfy the requirements of 414(s). By excluding overtime pay from compensation, you do not know that your compensation is non-discriminatory until you do the ratio test described in previous posts.

Some plan documents provide some flexibility in what compensation is used in ADP/ACP testing, some do not. One particular plan that I administer states that any definition of comp that satisfys 414(s) can be used in the discrim testing. So if I can't pass ADP/ACP with their goofy plan definition of comp, I just try the test again using gross comp. Check your plan document to see if it can help.

[This message has been edited by Beavis (edited 10-15-98).]

[This message has been edited by Beavis (edited 10-15-98).]

[Guest kp]

When you say that the bonuses are also excluded from the compensation, is it compensation for the purposes of determining who is HCE vs. NHCE?

[Guest Beavis]

Sorry, I changed my previous post on you. But no, you cannot exclude any comp in determining who is an HCE and who is not.

[Guest kp]

Assume it is proper to exclude OT in 401(k) calculation for salary deferral, and we're including OT for determining HCE status. Doesn't the the exclusion of OT from the deferral tend to discriminate in favor of HCEs in the testing?

(My numbers did not line up in my last post.)

method excluding OT in defn of compensation

comp = 50,000

election = 10% compensation

EC = 5K

ADP = 10%

method including OT in definition of comp

comp = 55,000 (50K + 5K OT)

election = 10% compensation

EC = 5.5K

ADP = 11%

[david shipp]

Assume you have already determined who HCEs are so we can ignore that issue. Now we look at compensation for determining deferral and compensation for ADP testing. In your example we have an employee who is deferring 10%.

Participant earned $50,000 in base comp

Participant earned $5,000 in OT.

Deferral is determined on base comp – 10% =$5,000

For ADP testing purposes we have to use a definition of compensation in the ADR denominator that satisfies 414(s). If, after running through the 414(s) tests, you find that base comp satisfies 414(s), the ADR for this participant is 10% ($5,000/$50,000).

However, if you find that base compensation does not satisfy 414(s) and you have to use total comp, the ADR becomes 9.1% (5,000/$55,000).

This obviously brings down the NHCE ADP making it harder to meet the ADP test.

Conceptually, the key is that increasing the amount of compensation used in the ADR denominator (relative to the compensation used to determine deferral) will decrease the ADR.

If the definition of deferral compensation satisfies 414(s) there is no problem. The participant's elected deferral percentage will equal his ADR. Where deferral compensation does not satisfy 414(s) and you have to bring exluded compensation back in for ADP testing purposes, the ADR will be less than the elected deferral percentage.