What Counts as 401(k) Eligible Compensation?

Saving for retirement through a 401(k) is a key way employees build long-term financial security. However, not all earnings count toward contributions. Understanding what qualifies as eligible compensation is important because it directly impacts how much can be contributed.

While certain types of income are always included, others may be excluded based on IRS rules or employer policies.

How Employers Calculate 401(k) Eligible Compensation

Employers determine eligible compensation based on IRS guidelines and their retirement plan documents. The IRS defines compensation under Section 415(c)(3) of the Internal Revenue Code, setting limits for contributions. While federal regulations provide a foundation, companies have flexibility in how they apply these rules.

The most common method is the “W-2 wages” approach, which includes all taxable income reported in Box 1 of an employee’s W-2 form. Some employers use an “income subject to withholding” approach, which includes all wages subject to federal tax withholding, or a “Section 3401(a) wages” method, which follows a broader definition. Each approach results in slight variations in what is eligible for contributions.

Employers must also comply with nondiscrimination testing to ensure highly compensated employees do not receive disproportionate benefits. Failing these tests can require corrective distributions or plan adjustments.

Typical Inclusions

Certain earnings are generally included in 401(k) contribution calculations. These typically consist of regular wages and other taxable income.

Base Pay

Base pay refers to an employee’s regular salary or hourly wages before bonuses or commissions. It is the most straightforward component of 401(k) eligible compensation.

For salaried employees, base pay is calculated as the annual salary divided by pay periods. For example, an employee earning $60,000 per year with biweekly paychecks receives $2,307.69 per pay period, which is eligible for contributions.

For hourly workers, base pay is determined by multiplying the hourly rate by hours worked. If an employee earns $20 per hour and works 40 hours per week, their weekly base pay of $800 is included in 401(k) calculations. Overtime is often included unless specifically excluded by the employer.

Commissions

Commissions, typically tied to sales performance, are usually included in 401(k) contribution calculations. These payments vary by pay period.

For example, a salesperson earning a 5% commission on sales receives $500 for every $10,000 in revenue they generate. If commissions are included in eligible compensation, a portion can be contributed to the 401(k).

Employers must ensure commissions are correctly accounted for in payroll systems. Some companies have specific rules on when commissions count toward contributions, particularly if they are paid quarterly instead of with regular paychecks.

Bonuses

Bonuses, including performance-based incentives, signing bonuses, and holiday bonuses, are generally included unless specifically excluded. These payments can significantly impact how much an employee can contribute.

For example, if an employee receives a $10,000 year-end bonus and bonuses are included in eligible compensation, they can defer a portion into their 401(k). However, IRS limits still apply. In 2024, the contribution limit is $23,000 for those under 50 and $30,500 for those 50 and older, including deferrals from bonuses.

Some employers offer a separate deferral election for bonuses, allowing employees to contribute a different percentage than from regular wages. This can help maximize retirement savings without affecting take-home pay.

Possible Exclusions

Certain types of earnings and benefits may be excluded from 401(k) contributions based on IRS regulations or employer policies.

Certain Fringe Benefits

Fringe benefits, such as employer-paid health insurance, tuition assistance, and transportation subsidies, are generally not considered 401(k) eligible compensation. These benefits are often excluded because they are non-taxable or do not represent direct earnings.

For example, if an employer provides $5,000 in tuition reimbursement under a qualified program, this amount is not included in taxable income and does not count toward 401(k) contributions. Similarly, employer contributions to health savings accounts (HSAs) or flexible spending accounts (FSAs) are excluded.

The IRS also excludes minor fringe benefits, such as occasional meals or small gifts, from taxable income. Since these benefits are not subject to federal tax withholding, they do not factor into 401(k) calculations.

Stock Options

Stock options and other equity compensation, such as restricted stock units (RSUs) and employee stock purchase plans (ESPPs), are typically excluded. These forms of compensation do not provide immediate taxable income like wages or bonuses.

For instance, stock options do not generate taxable income until exercised. Even then, the income is usually reported as capital gains rather than wages, so it does not count toward 401(k) limits. RSUs are taxed as ordinary income when they vest, but unless specifically included in the plan, they are not eligible for deferral.

Employees receiving a significant portion of their earnings through stock-based compensation should consider alternative retirement savings strategies, such as contributing to an IRA or investing outside their employer-sponsored plan.

Non-Taxable Reimbursements

Expense reimbursements, such as per diem allowances, mileage reimbursements, and relocation stipends, are usually excluded since they are not taxable income.

For example, if an employee receives a $500 reimbursement for travel expenses, this amount is not included in taxable wages and does not count toward 401(k) contributions. Similarly, a $3,000 relocation stipend is typically excluded unless structured as a taxable bonus.

The IRS requires reimbursements to follow an “accountable plan,” meaning employees must substantiate expenses with receipts and return any excess funds. If an employer provides a flat allowance without requiring documentation, the payment may be treated as taxable income and could be included in 401(k) calculations.

Employer-Specific Guidelines

Employers have discretion in defining 401(k) eligible compensation within IRS regulations, meaning plan provisions vary. Employees should review their Summary Plan Description (SPD) to understand their employer’s specific calculations.

Businesses with fluctuating income structures, such as consulting firms or investment banks, may structure plans differently than those with stable wages. A financial services firm with high bonuses might cap deferral percentages on lump-sum payments to prevent employees from exceeding IRS contribution limits too early in the year. Conversely, a manufacturing company with hourly workers may include overtime and shift differentials to allow employees to maximize contributions.

Some employers offer nonqualified deferred compensation (NQDC) plans for highly compensated employees who exceed IRS contribution limits. These plans operate under different tax rules and require careful coordination to avoid exceeding allowable deferral amounts.