Retirement plans can be a significant factor that prompts employees to commit to organizations in the long run. As a result, employers and employees should have a basic understanding of IRC Section 3401 and its implications on retirement plans.
This section of the IRC is essential for 403(b) plan holders because it outlines the tax-exempt rules organizations and public schools must follow when withholding a portion of their employees’ salary and contributing it to this plan.
Familiarity with Section 3401 can also benefit new businesses searching for the right retirement plan they intend to offer their employees.
Let’s dive deeper into IRC Section 3401 and explore how it affects retirement plans.
Table of Contents
Overview of IRC Section 3401
The section defines the term wages for federal income tax withholding and retirement plan purposes. It’s often referred to as the pay stub compensation definition because Section 3401(a) implies that only wages listed on an employee’s pay stub are subject to withholding.
This section of the IRC defines wages as:
‘The term wages means all remuneration (other than fees paid to a public official) for services performed by an employee for his employer.’
The definition indicates that employers must withhold federal taxes from the following income types:
- Wages.
- Salaries.
- Tips (over $20 per month).
- Bonuses.
- Relocation expenses.
- Salary reductions.
- Insurance premium commissions.
- Unfunded unqualified plan receipts.
- Sales commissions.
According to Section 3401, the property or restricted stock at risk of forfeiture is also subject to federal tax withholding if such risk no longer exists. In addition, employers must withhold taxes from non-qualified stock options added to the income during a tax year.
However, income from sales of qualified stock options is excluded from Section 3401(a) compensation definition.
Comparison of W-2 and 3401(a) Wages
Group term life insurance over $50,000 is the most significant difference between W-2 and 3401(a) wage definitions because IRS Section 3401 doesn’t indicate that group life insurance over $50,000 should be treated as income.
Both definitions are similar to the IRC Section 415(c) Compensation definition, with the biggest difference being that the statutory definition also includes taxable disability and medical benefits.
Neither definition of compensation in the IRC includes the following sources of income:
- HSA employer contributions.
- Worker’s compensation.
- Nontaxable fringe benefits.
- Severance pay.
3401(a) wages generally include fewer pay codes than the W-2 compensation definition, which can affect how the retirement plan’s 415 limits are calculated.
For instance, in 2023, the maximum salary deferral is $22,500, the annual addition contribution is $66,000, and the yearly compensation limit applicable to 401(k) retirement plans is $330,000.
The same limits apply to 403(b) plans that commonly rely on Section 3401(a) wage definition.
The Importance of Section 3401 for Retirement Plans
The important thing to note is that employers can choose which compensation definition best matches their retirement plan. Hence, an employer doesn’t have to opt for the 3401(a) definition if they think the W-2 wage definition better fits their established plan.
Most 403(b) plans refer to Section 3401(a) compensation definition to determine which income sources should be excluded from federal taxation. This is because 403(b) contributions are allocated to individual accounts, and they’re not taxed until the taxpayer uses the allocated funds.
However, opting for a ROTH account will immediately make 403(b) contributions subject to federal taxes, but the remaining amount will be tax-free when distributed.
It’s worth noting that 403(b) plans are commonly offered by these employers:
- Public schools and universities.
- Hospitals.
- Tax-exempt organizations.
- Ministers.
Employees that already participate in a 401(k) or 457(b) plan cannot contribute to a 403(b) plan. In addition, you may not be eligible for this plan if you work less than twenty hours per week or contribute less than $200 per year.
High administrative costs and limited investment options are some of the most significant downsides of the 403(b) plan.
Frequently Asked Questions
403(b) title refers to tax-sheltered annuity plans commonly available through charitable organizations and public schools.
This section of the IRC specifies that the compensation paid for services performed by an employee of a foreign government is not treated as wages. As such, it isn’t subject to federal taxation.
According to Section 3401 of the IRC, any individual or organization that hires employees to perform a service of any nature, temporarily or continually, is considered an employer.
All amounts paid to an employee under a medical plan are excluded from the Section 3401 compensation definition if they’re includable in the annual income.
Author:
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.
