The Hidden 401(k) Risks of Equity Compensation in Growth Companies

Bridging the disconnect between equity compensation and 401(k) plans

Key Takeaways

• Equity compensation can quietly create 401(k) contribution gaps when stock options or RSUs are processed outside of standard payroll.

• Reviewing how your plan defines “eligible compensation” helps ensure equity income is handled correctly for deferrals and compliance testing.

• Coordinating payroll, HR, and plan administrators can prevent missed contributions and strengthen overall plan compliance.

Did your last equity award, whether a stock option exercise or restricted stock unit (RSU) vesting, quietly trigger a 401(k) contribution gap?

Equity compensation, such as stock options and RSUs, are hallmarks of startup and high-growth company culture: they reward loyalty, attract talent, and align employees with company success. Yet when a company also sponsors a 401(k) plan, these same equity awards can create operational challenges that often go unnoticed.

Determining whether a deferral was missed can be surprisingly complex, especially when equity compensation is processed outside of standard payroll systems. Misalignments between plan language, payroll processes, and 401(k) administration may result in contributions being unintentionally overlooked. Let us explore why this happens, what to watch for, and practical steps to reduce operational risk.

1. Eligible compensation and operational nuance

Every 401(k) plan defines eligible compensation in its adoption agreement, commonly W-2 wages, Internal Revenue Code (IRC) Section 3401(a) wages (subject to income tax withholding), or IRC Section 415(c) compensation (used for annual addition limits). Plans may also exclude certain items, such as overtime, bonuses, fringe benefits, or equity compensation (often referred to as stock-based compensation in plan documents). If the plan does not explicitly exclude stock-based compensation, it may fall within the plan’s definition of eligible compensation, particularly under W-2 or IRC Section 415(c) definitions. However, treatment can vary depending on the plan’s specific compensation base and the type of equity compensation involved.

When stock-based compensation, such as stock options and RSUs, is considered eligible under the plan’s definition, the main risk lies in how these taxable awards are processed. Because they generate taxable income without actual cash paid, misalignment between payroll and 401(k) systems can result in missed deferrals. Irregular timing and large award amounts make these gaps easy to overlook, quietly leaving employees under-deferring and companies exposed. These operational nuances, as well as the interpretive gray areas explored in the next section, can, if unmanaged, create ripple effects across payroll, compliance testing, and contributions.

2. A note on the gray area (and why there is no one-size-fits-all answer)

These operational challenges are compounded by interpretive ambiguity. Even among plan administrators and benefits professionals, opinions vary. If you have searched for guidance on whether stock-based compensation counts as eligible 401(k) compensation, you have likely seen conflicting answers or simply been told it is “tricky.” That is because the right approach depends on plan language, payroll mechanics, and timing of compensation recognition.

Some argue that 401(k) deferrals can only come from compensation that is “available” in cash. However, in one real-world case, an attorney specializing in the Employee Retirement Income Security Act (ERISA) concluded that a client should defer from non-cash equity compensation, even though it appeared on a separate check with no cash to defer from. Because the compensation appeared on the W-2, it met the plan’s definition of eligible compensation creating an obligation to defer even though no cash was available.

Even if deferrals are not applicable, equity compensation may still be considered eligible for other purposes, such as compliance testing and employer contributions. In these cases, it should be included in the payroll feed or census used for these tests.

3. Real-world scenario (illustrative)

Imagine a fast-growing tech company with both a 401(k) plan and stock options. In December, an engineer exercises $80,000 of vested nonqualified stock options (NQSOs). Payroll withholds $32,000 for taxes, but no 401(k) deferral is applied because the equity compensation was processed separately from regular payroll.

Operationally, the systems did not capture the deferral – even though, under the plan’s definition of W-2 wages, the equity compensation counts as eligible. Because the deferral was missed, the company would need to make a corrective contribution to the employee’s account.

Illustrative corrective contribution (example only):

• Employee elected 10% deferral
• $80,000 of eligible compensation = $8,000 deferral
• Qualified Nonelective Contribution (QNEC) at 50% = $4,000
• Company match (50% of $8,000) = $4,000

Total illustrative contribution: $8,000

When multiplied across multiple employees, these operational gaps can add up quickly. In this case, the company would need to make a QNEC, an employer-funded correction typically equal to 50% of the missed deferral amount, plus lost earnings to reflect what the employee’s account would have earned if the deferral had been captured when the compensation was recognized.

4. Why growth companies are especially vulnerable

Fast-growth companies face unique challenges when managing equity compensation (including stock-based awards) alongside 401(k) plans:

• Bursts of equity activity – Clustered exercises, tender offers, or secondary sales can create spikes in taxable compensation that are not part of regular payroll.
• System gaps – Payroll, HR, equity administration, and recordkeeping systems rarely communicate seamlessly, and deferrals from irregular or supplemental equity payments may not automatically flow into 401(k) calculations.
• Timing and eligibility issues – Equity exercises or disqualified dispositions of incentive stock options (ISOs) after employee terminations can complicate whether deferrals are applicable, depending on when the income is recognized relative to the plan’s post-termination deferral period.
• Operational gaps that compound over time – Even technically eligible compensation can be overlooked if internal procedures are not well-defined, sometimes going undetected for years.

By acknowledging both the operational and timing challenges, companies can better target the areas where errors are most likely to occur and focus on controls that prevent missed contributions.

5. Practical steps to reduce operational risk

• Review your plan document. Confirm whether taxable equity compensation is included or excluded and make any exclusions explicit if intended.
• Audit payroll-to-plan feeds. Verify that taxable equity compensation is coded correctly and consistently flows into 401(k) calculations.
• Establish procedures for equity events. Flag exercises, vesting, or ESPP purchases for review and document how they are handled operationally.
• Coordinate with your plan recordkeeper. Ensure compensation used for deferral calculations matches the plan’s definition.
• Educate stakeholders. CFOs, controllers, and HR teams should understand that eligible compensation may include non-cash items, and proper coding drives accurate contributions.

If your plan has not specifically addressed how to handle stock-based compensation, do not wait for your next audit to find out. Discuss it with your TPA or ERISA counsel now. Proactive coordination is key.

Summary

Equity awards and 401(k) plans are both powerful tools for attracting and retaining talent. The real risk often lies not in legal interpretation but in operational execution.

By reviewing plan definitions, auditing payroll-to-plan feeds, and educating your teams, companies can reduce the chance of overlooked contributions, even when equity compensation creates taxable income without cash.

Key reminders:

• Do not assume “non-cash” automatically means “non-deferrable.” Confirm how equity compensation is handled in payroll and your plan’s definition of compensation.
• Check your plan’s definition of eligible compensation.
• Ensure payroll and equity systems feed accurately into 401(k) calculations.
• Document procedures for handling equity events to prevent gaps.

Clear processes around equity and 401(k) contributions build employee trust and strengthen compliance.

Curious how equity-based compensation events might be creating hidden gaps in your 401(k) plan operations?
We are happy to share insights or help you assess potential risks and next steps. Contact your Keiter Opportunity Advisor to start a conversation.

This article and illustrations should not be considered legal or tax advice. It is an observation-based discussion meant to illustrate why treatment can be complex and inconsistent—and why companies should review plan language, payroll operations, and coordinate with their third-party administrator (TPA) and ERISA counsel. If your plan does not explicitly exclude stock-based compensation and deferrals have not historically been made, work with your TPA and ERISA counsel to determine whether a correction is needed and consider amending the plan to explicitly exclude these wages going forward.

Resources and Further Reading

• IRS 401(k) plan Fix-it Guide – You didn’t use the plan definition of compensation correctly for all deferrals and allocations
• IRS Fixing common plan mistakes – Correcting a failure to effect employee deferral elections
• IRS General Instructions for Forms W-2 and W-3
• IRS Publication 15-B: Employer’s Tax Guide to Fringe Benefits
• eCFR 26 CFR § 31.3401(a)-1 – Definition of Wages
• eCFR 26 CFR § 1.415(c)-2 – Definition of Compensation