Establishing a 401(k) retirement program for your business, however, requires owners to decide what the eligibility requirements will be for employee participation. There are a variety of options on this front, some of which can be beneficial for the employee, while others are beneficial for your business.
The eligibility rules you establish can also impact the plan’s overall cost to your business, not to mention how valuable employees perceive the 401(k) plan to be. Here’s a closer look at the process of creating eligibility rules for your company’s 401(k) plan and some of the most important factors to consider.
What are 401(k) eligibility requirements and why are they important?
Eligibility rules are essentially conditions that must be met by employees in order to participate in your 401(k) program. While these rules are largely established by the plan sponsor, they must also abide by a few legal parameters as well (more on that later).
When considering the eligibility rules for your company’s 401(k) plan, it’s important to understand that your decisions can impact how much the plan costs your company. If eligibility requirements, for instance, are too loose, it may drive up the expenses associated with your 401(k) program. On the other hand, if eligibility requirements are overly strict, it may impact not only participation but also your ability to attract talented employees.
The eligibility requirements you establish will also impact how much administrative work is involved for your business.
For these reasons, it’s important to carefully consider your business’s capabilities, needs, and long-term goals when establishing 401(k) eligibility requirements.
Eligibility requirements: Length of service, age, entry dates
The IRS has established some basic parameters regarding the eligibility requirements for employee participation in 401(k) plans. According to the IRS, employees must be allowed to participate if they meet the following criteria:
1. Has reached the age of 21
2. Has at least one year of service
Retirement plans that meet these requirements are considered "qualified plans." Operating a qualified plan includes benefits for both the employer and the employee, including significant tax benefits such as the ability to take a deduction for contributions to the plan if you are the employer and the ability to shelter income and plan earnings from income tax until retirement funds are distributed, if you’re a plan participant, according to the IRS.
When establishing a 401(k) plan for your business, you can choose to follow the IRS guidelines for eligibility requirements, or you can make the requirements less stringent, but the requirements cannot be made more stringent than the criteria set forth by the IRS. Here are some additional requirements considerations.
Length of service
Length of service is one of the primary eligibility criteria used. While the IRS dictates that employees must be allowed to join a 401(k) program after one year of service, that’s not the only option available. Businesses can also allow new employees to become plan participants immediately upon hire. Or, they can require that they wait three to six months, for example. Employers are allowed to decide on the minimum service requirement as long as it does not exceed one year.
There are various benefits associated with the timeline that you choose. For instance, requiring that employees wait one full year before being eligible to participate can reduce plan costs if your business experiences significant turnover.
However, if you’re using a 401(k) program to help attract talent, a lengthy waiting period, like one year, may hamper recruiting efforts. In such cases, it may be more helpful to have a shorter service requirement, such as three to six months, or allow participation immediately upon being hired.
Age requirements
Here too, the IRS has established some legal guidance, stipulating that once an employee reaches the age of 21, they must be eligible to participate in a 401(k) program. However, businesses can also allow employees to participate prior to turning 21. You might decide to allow employees as young as 18 to enroll in your company’s 401(k) program. Or you may opt to forgo establishing a minimum age altogether.
What businesses may not do is exclude an employee because “he or she has reached a specified age,” according to the IRS. This means you cannot bar older employees from participating in a 401(k) program.
Entry dates
In addition to age and length of service requirements, employers can also establish annual entry dates for program participation. In other words, once employees have met your plan’s age requirements and length of service requirements, can they enroll immediately? Or will you allow entry on a quarterly basis, for instance? Or a semi-annual basis? Or at some other interval? Limiting enrollment to specific time periods can cut down on the administrative work for your business.
Safe Harbor match requirements
While employers must allow employees who are otherwise eligible to begin making elective deferrals to a 401(k) after no more than one year of service, you can, however, stipulate that matching contributions will not be made until an employee has reached two years of service, according to IRS rules.
On this front, the IRS explains: “A traditional 401(k) plan may require two years of service for eligibility to receive an employer contribution if the plan provides that after not more than 2 years of service, the participant is 100% vested in all plan account balances.”
This dual approach can be beneficial if you're using 401(k) benefits to attract employees but also have a history of high turnover and want to limit the contributions you make to those employees who stay with your company for a longer duration.
Who can and cannot be excluded?
One final consideration, the IRS also identifies specific types of employees that can be excluded from 401(k) plans, even if they’ve met age and length of service requirements. As a business owner, it’s important to be equally familiar with these regulations.
For instance, the IRS says some employees may be excluded from a 401(k) plan if they “are covered by a collective bargaining agreement that does not provide for participation in the plan if retirement benefits were the subject of good faith bargaining.”
In addition, nonresident aliens may also be excluded. This means employees who are not residents of the US and who do not get paid on a U.S. payroll.
Separately, part-time employees were once excluded entirely from participation in such plans. But the passage of the SECURE Act (Setting Every Community Up for Retirement Enhancement), which was adopted in 2019 and enacted in 2020, changed that.
As part of that measure, long-term, part-time employees who work at least 500 hours over the course of three consecutive years and who are at least age 21 must be allowed to participate in 401(k) plans.
The takeaway
There are many different variables to consider when establishing employee participation requirements for your business’s 401(k) plan. It’s important to understand the financial and administrative ramifications of each of the requirements you choose to adopt, not to mention the implications for attracting and retaining talented employees.
If you have questions about establishing eligibility requirements, contact Penelope to discuss our retirement plans, which are designed specifically with your small business in mind.
If you have questions about setting up a retirement plan, schedule a quick call with a retirement specialist today. We’ll walk you through your options and help you find the best plan for you and your employees.
Penelope Team
Mia Taylor