A widely discussed but frequently misunderstood topic that is critical to a qualified plan’s operations and compliance is post-severance compensation. An incorrect interpretation could result in costly and/or time-consuming corrections – whether it’s resolved through an interaction with the Internal Revenue Service or through self-correction.

The Department of Labor defines severance pay (sometimes also called parachute payments) as a payment for which an employee is eligible if she is terminated from employment. The payment amount is typically based on length of service. In other words, it is not based on services rendered nor would it have been paid had the individual remained employed. Such payments are not required of employers.

So what is post-severance compensation? What is included and excluded? Are there any exceptions to the definition? What is its significance in the context of retirement plans?

Post-severance compensation must meet both of the following conditions to be included for determining retirement plan benefits.

1. The amounts paid to the participant are amounts that would have been paid for services rendered if the participant had continued employment.
2. The payment must be made by the later of:

• • 2½ months following the severance from service, or
  • the end of the limitation year that includes the severance from employment date.

NOTE: The second condition is often called the 2½-month rule. The limitation year is defined by the plan document. It is commonly the plan year unless the employer has chosen another 12-month period.

Post-severance compensation may include regular pay, overtime, shift differentials, commissions, bonuses or other similar payments unless specifically excluded by the plan. Two common exclusions are unused leave cash-outs (e.g., bona fide sick leave, vacation pay or other leave) and deferred compensation (i.e., payments from a nonqualified unfunded deferred compensation plan that are includable in the employee’s gross income).

Plan permitting, two additional inclusions (that are not subject to the 2½-month rule) are differential pay due to military service and fixed or determinable payments to non-highly compensated employees when they incur a disability (as defined by the plan document).

The following are examples of common situations that plans encounter. (In each example, assume that the plan has no exclusions, and that the limitation year is the calendar year.)

A participant terminated employment on Nov. 30, 2023. The participant’s post-severance compensation would include payments received by Feb. 15, 2024 (2½ months after the severance date).

A participant terminated employment on Sept. 1, 2023. The participant’s post-severance compensation would include payments received by Dec. 31, 2023 (the end of the limitation year that contains the severance from employment date).

A participant terminated employment Aug. 1, 2023, but as a commissioned sales employee, will continue to receive monthly payments until July 30, 2024. Assuming the plan does not exclude commissions, this participant’s post-severance compensation would include commissions received until the end of the limitation year or Dec. 31, 2023. Anything thereafter would not be included.

A participant terminated employment Oct. 1, 2023. She will receive an amount equal to six months of her salary divided by the three months following the severance from employment date. This is considered severance pay because it is not a payment for services rendered to the employer (a parachute payment): it is not considered post-severance compensation – even though it’s paid during the following 2½ months, and is not considered for plan benefit purposes.

Note: Payment of discretionary severance pay (i.e, a parachute payment) that begins before the severance date is a new trend, one that may create ambiguity when determining a terminating employee’s entitlement to retirement plan benefits. Under current rules, there is potential to create a compliance problem if the employer includes them but can’t justify the payments as having been earned. Discussion of the issue with an employer’s legal counsel or tax professional is advised.