Certified Plan Sponsor Professional (CPSP) Practice Exam

What is the most common risk associated with using different definitions of compensation in a 401(k) plan?

1. Exceeding annual contribution limits

2. Failure to apply the correct definition of compensation

3. Incorrect tax reporting

4. Overvaluation of plan assets

The correct answer is: Failure to apply the correct definition of compensation

Using different definitions of compensation within a 401(k) plan can lead to significant discrepancies in how employees’ contributions are calculated and managed. The most common risk associated with this practice is the failure to apply the correct definition of compensation. This can result in inconsistencies in the amount that employees are allowed to contribute to their 401(k) accounts, which directly affects their retirement savings. When a plan sponsor uses multiple definitions for determining compensation, it can create confusion not only among plan participants but also among those administering the plan. For instance, if one definition includes bonuses while another does not, employees may either under-contribute or over-contribute based on their understanding of what constitutes their eligible compensation. This misapplication can lead to compliance issues with IRS regulations, necessitating corrective action which can be time-consuming and costly. Correctly defining compensation ensures that participants are treated equitably and helps maintain the integrity of the plan, ensuring that contributions are accurately tracked and reported. It is essential for plan sponsors to adhere strictly to a single, clear definition to minimize risks and ensure compliance with regulations, thus safeguarding both the plan and its participants.