Can employees make 401(k) contributions from severance payments?


Your company will be having a reduction in force, and you are planning to offer laid-off employees severance benefits, including severance payments. For laid-off employees who are participants in the company's 401(k) plan and have elected to defer compensation into the plan from their regular pay, will their deferral elections apply to the severance payments?


No. For a participant's compensation to be deferred into a 401(k) plan, the amount must meet the 401(k) plan's definition of "compensation," which must comply with Internal Revenue Code Sec. 415. Generally, to be treated as compensation under that provision, the compensation must be paid or treated as paid to the employee before he or she separates from employment. A plan may provide for certain exceptions — for example, compensation paid after termination of employment that is regular compensation for the employee's services, commissions, bonuses, or similar payments, or other payments that would have been made to the employee if the employee had continued in employment, provided that:

      1. the amounts are paid by the later of two and a half months after severance from employment or the end of the plan's limitation year that includes the date of severance from employment; and
      2. the amounts would have been included in the plan's definition of "compensation" if they had been paid before the employee separated from employment.

Any post-termination payment that does not meet one of the exceptions in the Internal Revenue Code Sec. 415 rules does not meet the provision’s requirements for the definition of "compensation." A severance payment, such as the one noted above, would not qualify. As a result, the laid-off employees will not be able to make deferrals into the 401(k) plan from their severance payments.

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