By Jenny Kiffmeyer, J.D – The Retirement Learning Center

Severance Pay vs. Post Severance Compensation

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with an advisor in Massachusetts addressed severance pay for plan purposes.  The advisor asked: “My client will be terminating an employee effective immediately and offering the individual a years’ worth of pay as a lump sum. Is this payment considered income for plan contribution purposes?”

Highlights of Discussion

With this case, it is important to make a distinction between Post-Severance Compensation and severance pay. Turn to the plan document to see how each is defined and used for plan purposes.

Generally, two criteria apply to Post-Severance Compensation:

1. It is payment for services rendered by the employee before termination that would have been paid to the employee had employment not ended [Treas. Reg. § 1.415(c)-2(e)(3) & (4)]. This can include not only regular pay,[1] but certain leave cash-outs (for sick time or PTO) and deferred compensation. The terms of the plan document should specify any exclusions that may apply from the general definition.[1] Generally, regular pay includes normal pay for services as well as commissions, bonuses, or other similar payments.
2. It is paid by the later of 2 ½ months after severance from employment with the employer maintaining the plan or the end of the limitation year that includes the date of severance from employment.

In contrast, an employer may give severance pay as a payment for the release of any legal liability that may arise from termination of an employee’s services. These types of payments are not given for personal services rendered; and they are not considered plan compensation, even if paid according to the 2 ½ months rule. [Treas. Reg. § 1.415(c)-2(e)(3)(iv)].

Conclusion

When a terminated plan participant receives an employer payment upon severance from employment, it is important to categorize the type of payment as either Post-Severance Compensation according to the terms of the plan document or severance pay to insure proper inclusion or exclusion for plan purposes.