Lump Sum Vacation Pay and Plan 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 is representative of a common question compensation for plan purposes. The advisor asked: “How is a lump-sum payout of unused vacation treated for plan purposes?”

Highlights of Discussion

• To answer this question, we need to consider two issues—ideally with the help of a tax advisor.  First, how does the IRS treat a lump-sum payout of unused vacation for tax purposes and, second, what is the definition of compensation for plan purposes according to the governing plan document? 

• The following is not tax advice, but a general explanation of the rules based on IRS source materials. With respect to the first question, the IRS treats a lump-sum payout of unused vacation as “supplemental wages” subject to Social Security and Medicare taxes according to the IRS Publication 15, (Circular E), Employer's Tax Guide.  Any federal income tax withheld will be at the IRS supplemental wage tax rate, depending on whether the supplemental payment is identified as a separate payment from regular wages or combined with regular wages. (For more information, please see Publication 15 and Treasury Decision 9276.) 

• Regarding question number two, as supplemental wages, a lump-sum payout of unused vacation would be included in the definition of compensation for plan purposes—unless it is explicitly excluded under the terms of the plan document. Therefore, be sure to check the wording of the plan document carefully.  

Conclusion

The IRS treats the lump-sum payout of unused vacation as supplemental wages for tax purposes. As supplemental wages, a lump-sum payout of unused vacation would be included in the definition of compensation for plan purposes—unless it is explicitly excluded under the terms of the plan document. For specific tax advice, please see the guidance of a tax professional.