For years, there was no guidance on the issue of whether post-severance payments made to employees could be used for qualified plan purposes (i.e., elective deferrals and matching and nonelective employer contributions). As a result, various interpretations existed.
Although the final 2007 Section 415 regulations provided guidance on this issue, some uncertainty remains as to what, if any, post-severance payments may be used for plan purposes. The 415 regulations provide that certain amounts earned during the participant’s employment but paid afterward are included in Section 415 compensation for plan purposes. Nonetheless, a common question that arises among plan sponsors, as well as participants, is just what type of post-severance compensation may be used for qualified plan contribution purposes, such as for 401(k) deferrals, and what type cannot be used. This article will parse out the particulars of these rules.
Section 415 Compensation Amounts
According to the regulations, a post-severance payment is to be included in compensation for qualified plan purposes if it meets all of the following criteria:
- The payment is regular compensation for services performed during an employee’s regular working hours or compensation for services performed outside the employee’s regular working hours (such as overtime or shift differential pay), a commission, bonus, or other similar payment,
- The payment would have been paid to the employee prior to the severance from employment if the employee had continued working for the employer, and
- The payment is made by the later of 2½ months after severance from employment or the end of the limitation year that includes the date of severance from employment with the employer maintaining the plan. So, as a rule of thumb for a plan with a calendar-year Section 415 limitation year, the 2½-month period for an employee who severs employment after October 15 will conclude later than it would for the employee who severs between January 1 and October 15, in which case the relevant date would be December 31.
Example: An employee who is paid by the hour terminates employment on November 30. Her paycheck at that time reflects payments for services through November 15 only. On December 15, the former employee receives a final paycheck for the amount she earned through November 30. This amount must be considered for Section 415 compensation purposes.
Commissions or bonuses earned while working and paid within the specified time period (the later of 2½ months or the end of the limitation year after severance) also must be considered for Section 415 compensation purposes.
Optional Compensation Amounts
The regulations address additional types of post-severance payments that an employer may choose to include as Section 415 compensation. Keep in mind that the compensation must be for services rendered before the employee ceased working to be eligible for qualified plan purposes. Examples include:
- Pay for accrued vacation, sick, and other leave that could have been taken had the employee continued in employment
- Pay differentials for employees who enter qualified military service
- Distributions from unfunded, nonqualified, deferred compensation plans actually paid by the later of 2½ months or the end of the limitation year after severance
Severance Pay Excluded From the Definition of Compensation
Post-severance payments other than those just described — including actual severance pay — are not includible as compensation for qualified plan purposes, even if they are paid within the specified time frame. Frequently, severance pay is a payment for the release of any legal liability arising from termination of an employee’s services. These types of pure severance pay — which are not payments for personal services rendered — are not considered plan compensation.
Section 415 Limit and the Compensation Cap
The regulations coordinate the Section 415 limit with the compensation limit defined under Section 401(a)(17), which is $265,000 for 2016. Here’s an example: An employee defers 5% of his salary per payroll on a salary of $360,000. His total deferrals for the year are $18,000 (the maximum allowed in 2016). But when the annual compensation cap under Section 401(a)(17) is applied after year-end, the employee’s deferral limit is measured against $265,000, rather than $360,000. Since he did not defer more than the Section 402(g) limit of $18,000, no amount is an “excess deferral” that needs to be returned. However, for testing purposes, the imposition of the Section 401(a)(17) limit will cause the deferral rate to be 6.79%, rather than 5%. (Note: There is no “excess deferral” because the plan did not limit elective deferrals to a rate, such as 6%, that was below the recalculated deferral percentage.)
Does an employee have to stop deferring as soon as the compensation cap of $265,000 is reached? No. The 415 regulations provide clarification. The 401(a)(17) compensation cap is an annual limit to be tested after year-end. Thus, if the employee deferred $13,250 on earnings of $265,000 by October and received a bonus in December, the employee could defer on the bonus with a separate deferral election at a higher percentage, even though the $265,000 limit was reached in October. This issue was addressed by the IRS in its electronic newsletter, Employee Plans News, Fall 2009 Edition. The article can be found on page four of the publication at www.irs.gov/pub/irs-tege/fall09.pdf.
A simple way to avoid this problem, if the plan document allows, is to defer a fixed dollar amount per paycheck rather than a percentage of compensation. Simply take the deferral limit for the year and divide it by the number of payroll periods for the year.
