A recurring issue encountered with many 401k audits is the treatment of severance and post-severance compensation. To properly determine if compensation paid to an employee during or after their severance is considered eligible compensation for 401k purposes, it is important to distinguish whether it is severance or post-severance pay. These terms are often used interchangeably, but the nature and the timing of the payment determine if the payment should be included or exclude in compensation for calculating elective deferrals for a 401(k) plan.

IRS Severance & Post-Severance Compensation Defined

To begin, a basic understanding of certain IRS regulations concerning compensation is required. Substantially, all 401(k) plans base their definition of compensation on one of the three safe harbor definitions included in IRS regulations. These three safe harbor definitions comply with §415 of the Internal Revenue Code, which is one of the two code sections where compensation is defined.  Under all three safe harbor definitions, severance pay disbursed after an employee’s termination of employment is excluded from compensation eligible for 401(k) deferral purposes, but post-severance compensation may or may not be included, depending on certain rules.

Severance pay is pay received by an employee as part of an agreement between the departing employee and the employer. It is often based on a combination of the employee’s current salary and years of service. The IRS regulations do not specify if severance pay distributed prior to termination of employment can be included. If you do pay severance pay prior to termination of employment, you should consult with your third-party administrator, auditor, or attorney to determine if 401k should be withheld.

Post-severance compensation is defined by the IRS as compensation that would have been paid if the severance had not occurred. It is important to note there are certain types of post-severance compensation that do qualify as compensation under the §415. If the post-severance compensation would have been paid had the employee not been severed from employment, such as compensation for hours worked up until the employee’s severance date but not paid until after the severance date, and the compensation is paid before the later of (1) 2 ½ months after severance or (2) the end of the plan year in which the severance occurs.

Post-Severance Pay Included in the Definition of Compensation

For example, an employee is severed on a Thursday. The employee has hours worked on Monday through Thursday of that week. Those hours are included in the employer’s payroll on the second Friday after the employee’s termination date. That compensation would be eligible for 401(k) deferral.

Post-Severance Pay Excluded from the Definition of Compensation

The amount of time between when an employee earns compensation and when it is paid can be longer in the case of commission pays, bonuses, etc. As another example, consider the following three facts: (1) a salesperson receives commission which is paid on the second pay in January of year 2 for sales in the fourth quarter of year 1, (2) this employee terminated employment on October 15 of year 1, but had sales that earned him commission for the period October 1 through October 15, and (3) the plan’s year end is December 31.

Since the second pay of January will be 2 ½ months after the employee’s severance and after the end of the limitation year, the compensation in this example would be excluded even if commission pay is normally included in the definition of compensation for non-severed employees.

Cash-Out Accrued Issues

One type of post-severance pay that can cause issues for employers is cash-out of accrued, but unused sick, vacation, or other leave that could have been used if the severance had not occurred. If employers pay out this type of compensation, they should specify in in their plan documents or adoption agreements whether this compensation is included or excluded and then make sure the plan document provisions are adhered to in practice.

Check with an Advisor 

If you need help in navigating through these complex IRS regulations or you suspect you may be calculating compensation for plan purposes improperly, you do not have to wait for the IRS or DOL to discover it. Review the compensation definition in your plan document and the provisions for severance pay with your plan’s advisor. Identification and correction issues are less painful and costly if completed prior to an IRS audit.

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