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HR Insights: Can Employer Skip 401k Deferrals on Bonus Checks?

A common question arises as year-end approaches and companies prepare to distribute performance bonuses: Can an employer turn off 401(k) deferrals for a bonus payroll? The short answer is yes, but doing so without reviewing the organization’s official 401(k) plan document can result in costly compliance failures.

Pitfall of “Compensation” Definitions
In the world of retirement plans, the plan document rules everything. Most 401(k) plans define eligible compensation using broad IRS definitions, such as W-2 wages. Under this standard definition, bonuses are automatically considered eligible compensation. If an employer manually toggles off 401(k) deductions in their payroll platform for a bonus run without a matching plan provision, they have committed an operational failure.

According to the IRS, failing to implement an employee’s deferral election on eligible compensation means the employer must fix the mistake. This typically requires funding a Qualified Non-Elective Contribution (QNEC) to make the employee whole out of pocket, plus paying for missed employer matching contributions and lost market earnings.

There are two ways to legally skip 401(k) deductions on a bonus check:

Plan Document Exclusions: The underlying adoption agreement or plan document must explicitly exclude bonuses from the definition of plan compensation. If it does not currently exclude them, the company must work with its Third-Party Administrator (TPA) or recordkeeper to formally amend the plan.
Separate Employee Elections: If the plan permits, employers can allow employees to submit a separate, specific deferral election for bonus payrolls, allowing them to choose a 0% deferral for that specific check.

Employers should also note that explicitly excluding bonuses can complicate mandatory year-end testing. The IRS requires plans to pass Section 414(s) compensation testing to ensure that the definition of compensation does not discriminate in favor of highly compensated employees (HCEs), who often receive larger proportional bonuses. Before making any adjustments in a payroll system, payroll should verify their plan document or consult their TPA to avoid triggering an expensive IRS correction process. Here are some additional resources to review.

IRS 401(k) Plan Overview: https://www.irs.gov/retirement-plans/401k-plan-overview
IRS Fix-It Guide – 401(k) Plan Correcting Common Mistakes: https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-mistakes-and-how-to-fix-them
Department of Labor (DOL) Retirement Plans Information: https://www.dol.gov/agencies/ebsa/key-topics/retirement-plans

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