Post-severance compensation that crosses plan years - practical operation

This issue is the bane of my existence. A plan participant terminates on 12/26/2025 and receives a final paycheck on 1/3/2026.  The paycheck is for hours worked in 2025.  They don't work any hours in 2026.  The plan is a safe harbor 3% non-elective plan.  Are they an employee in 2026 who is includable and should receive contributions or because they aren't actively employed in 2026, do you treat them as not existing in 2026 for Plan purposes?  

The paycheck is $50.   

Do you allocate the $1.50 or do you just ignore it?  What if the plan doesn't allocate contributions until into the next plan year (2027) and the participant already took their distribution.  Do you actually have the Plan Sponsor fund that $1.50?

Do you ask your plan sponsors to provide you any compensation someone in this scenario earned and pick it up in 2025?

I believe the technically correct to the penny answer is they get the $1.50 in 2026, but what are you doing in actual practice?  Do you have a threshold for what you pass on providing?  

Same scenario, but the plan is an ADP testing plan.  Would you pull that person into your testing?  

I realize that common sense isn't all that common, but this is an area where it should be applied, IMO.  This is just such a pain to administer and am curious what others do.

Begin by reading, carefully, the plan’s definition of compensation, at least the definition for compensation to determine allocations of the nonelective contribution.

Next, if relevant, consider when the check was drawn and when it was sent.

If the distributee received the paycheck on Saturday, January 3, might the employer have paid that money in December? (Thursday, January 1, was likely not a business day, and Wednesday, December 31, was still 2025.)

@Peter Gulia is on target with suggesting the plan to start is the plan's definition of compensation.  Be aware that some plan documents have separate sections that address post severance compensation for various purposes such as calculating contributions or 415 limitations.  Any operational practice must conform to a reasonable and consistent interpretation of the formal plan documentation.

Your question, appropriately, asks about what is done in actual practice.  When discussing the practicality of determining in which plan year compensation should be recognized, a precursor is understanding the employer's payroll practice and also understanding the accounting method.  For example, are employees paid in arrears (after the time when they worked) and, if so, how long past that time?  Are employees paid in advance (which is sometimes done for salaried employees)?  Is there a mix of payroll practices within the employer (such as hourly versus salaried)?  With respect to the accounting method, how is payroll reported for W-2s and for financial reporting?

 Ideally, how amounts that straddle a plan year are treated will be as consistent as practical for plan purposes (contributions, deferral limits, annual additions, HCE determination...), for employee purposes (W-2, tax withholding, health & welfare benefits, insurance...), and the basis for employer financial reporting (cash, accrual, or on a 5500 - modified cash).

Taken together, all of the above doesn't answer your specific question.  The answer will be derived from having uniform and consistent payroll and plan accounting practices that do not violate the plan provisions.

While a plan’s administrator must read the documents governing the plan, many plans put compensation in the period in which it was or is paid.

That often is so even if that’s not the period in which a worker’s service earned the compensation.

That often is so even if the retirement plan’s measure is inconsistent with an employer’s accounting for when the compensation is the employer’s expense.

If the plan’s provisions for defining compensation and putting it in a period result in compensation in a period in which the participant is not an employee or deemed employee, look to other plan provisions to discern whether a nonelective contribution is allocated.

This is not advice to anyone.