In This Issue:
- Minimum Age and Service Requirements
- Entry Date
- Effect of a Short Service Requirement
- Excluding Classes of Employees
- Excluding Part-Time Employees with a Fail Safe Provision
- Service Requirements for Employer Contributions
- Impact on ADP and ACP Tests
- Making Excluded Participants Whole
More and more businesses are hiring part-time, seasonal
or temporary employees (collectively referred to in this newsletter as
“part-time employees”). Employers believe the advantages to using this
alternative workforce include lower wages and significant savings in terms of
not providing employee benefits to these individuals.
Unfortunately, many 401(k) plan sponsors are under the misconception that all
part-time employees can automatically be excluded from participation in their
plans when, in fact, the Internal Revenue Code does not permit a plan to include
a blanket exclusion of part-time employees.
A qualified plan may be drafted to require that an employee work a minimum
number of hours to enter the plan, but the maximum number of hours that can be
required in a twelve-month period is 1,000. This maximum translates into an
average of a little over 19 hours a week, making many part-time employees
eligible for plan participation.
This newsletter will describe the minimum service requirements for 401(k)
plans and the effects of improperly excluding part-time employees.
Qualified plans are permitted to require an employee to satisfy minimum age
and service requirements in order to become a participant in the plan. The
maximum permissible service requirement for salary deferrals is one year of
service, generally defined as the twelve-month period, beginning on the
employee’s date of hire, during which the employee has worked at least 1,000
If the 1,000-hour requirement has not been met at the end of the initial
twelve-month period, many plan documents will switch to the plan year for
measuring future service computation periods. Up to two years of service may be
required for employer contributions to non-safe harbor 401(k) plans, but
employees must then become 100% vested immediately upon plan entry.
The plan is also permitted to set a minimum age requirement. The maximum
permissible is age 21.
Once employees have met the age and service requirements for the plan, they
will enter the plan on the entry date specified in the plan document. Common
entry dates for 401(k) plans are the first pay period after meeting the
eligibility requirements or the first day of the month or quarter after the
requirements have been met (in general, semi-annual entry is the maximum
Example: Eagle Company requires one
year of service with 1,000 hours to become eligible to participate in its 401(k)
plan. Employees enter the plan the first day of the month following completion
of the service requirement. Ken is hired part-time on June 13, 2014. As of June
12, 2015 he has had 930 hours of service. He has not met the plan’s service
The plan document requires that future service
computation periods be measured based on the plan year. The next computation
period begins on January 1, 2015 and extends through December 31, 2015. During
this period Ken has 1,050 hours of service. He has now satisfied the service
requirement and will be eligible to enter the plan effective January 1, 2016.
In order to attract qualified employees, an increasing number of 401(k) plan
sponsors are utilizing less than the maximum one year of service requirement.
Some are offering immediate entry, at least for the salary deferral portion of
the plan. A shorter service requirement or immediate participation could
potentially cause all part-time employees to become plan participants. Generally
most employers want to avoid including part-time employees in their plans
- These employees generally have little interest in participating in the
plan but are still required to receive enrollment materials and a summary
plan description on a timely basis once they have met the plan’s eligibility
- If the plan is top heavy (a plan where the key employees’ account
balances make up 60% or more of the total plan assets), minimum
contributions of up to 3% of compensation may be required for active
participants, whether or not they have elected to make salary deferrals and
regardless of the number of hours worked during the plan year; and
- Increased administrative expenses.
Plan documents usually exclude union and nonresident alien employees. Other
classifications may be excluded on a discretionary basis if based on objective
business criteria, such as hourly employees or a specific division of the
company. However, it is not permissible to exclude part-time employees as a job
classification because this exclusion may result in the plan violating the
maximum service requirement.
IRS auditors have been directed to carefully scrutinize plans that attempt to
exclude employees who have satisfied the 1,000-hour requirement by disguising
them as a certain class of employees who are excluded from coverage.
Even when a plan properly excludes certain classifications of employees, it
is required to pass additional tests to ensure the exclusion does not
discriminate in favor of highly compensated employees (HCEs). In general, an HCE
is anyone who directly or indirectly owns more than 5% of the plan sponsor or
who earns more than an indexed dollar amount during the immediately preceding
year ($120,000 for 2016).
There is a way for the plan to allow full-time employees immediate entry and
minimize part-time employee eligibility. The IRS has provided clear guidance and
examples of how a plan document may be designed to exclude part-time employees
without violating the 1,000-hour service requirement.
The plan could provide immediate eligibility for full-time employees but
require one year of service for employees who are scheduled to work less than
1,000 hours during the year as long as the plan includes fail-safe language that
says such employees will become participants if they actually work more than
1,000 hours during a computation period.
Just because a part-time employee has satisfied the plan’s age and service
requirements and has become a participant in the plan does not automatically
mean that he or she is entitled to receive an employer contribution unless the
plan is top heavy. The plan may require a minimum number of hours of service
during the plan year (1,000 is the maximum) and/or employment on the last day of
the plan year to receive an allocation of the employer contribution.
Example: Dove Company’s 401(k) plan
eligibility requirement is one year of service with 1,000 hours. Employees
become eligible to make deferrals and receive matching contributions the first
day of the month following completion of the service requirement. In order to
share in the matching contribution, the participant is required to work 1,000
hours during the plan year.
Barbie was hired part-time on April 16, 2014. As of
April 15, 2015 she had 1,020 hours, became a participant on May 1, 2015 and
began making deferrals to the plan. For the plan year January 1, 2015 through
December 31, 2015 she worked 975 hours. Since she had less than 1,000 hours
during the plan year, she is not eligible to share in the matching contribution.
A plan that requires active participants to have a minimum number of hours of
service during the plan year or terminated participants to have more than 500
hours of service in order to be eligible to share in the employer’s contribution
(matching and/or profit sharing) will be subject to nondiscrimination testing.
The Average Deferral Percentage (ADP) test is performed on employee deferrals
while the Average Contribution Percentage (ACP) test is performed on matching
and/or voluntary after-tax contributions (other than Roth deferrals). The
percentages for each employee within the HCE and non-HCE (NHCE) groups are
totaled and averaged to get the ADP and ACP for each group. The averages for the
HCE group may not exceed a specific ratio of the average for the NHCE group.
In performing the ADP test, all active and terminated employees eligible to
defer at any time during the plan year are included, whether or not they
actually made a deferral. In general, the ACP test includes all active and
terminated employees who met the plan’s requirements to receive a match
regardless of whether they actually made a deferral and received a match.
Plans that do not pass the test(s) must take some action, such as corrective
distributions or additional employer contributions. Corrective distributions
generally must be made within 2½ months after the end of the plan year to avoid
a 10% excise tax. Improperly excluding part-time employees who have satisfied
the eligibility requirements will cause these tests to be performed incorrectly,
possibly resulting in corrective action not being taken on time for failed
Qualified plans that have improperly excluded part-time employees from
participation are required to make these individuals whole. Failure to make the
necessary corrections can result in severe monetary penalties and possible plan
disqualification if discovered on plan audit.
The IRS recently updated its pre-approved correction program for a failure to
include an eligible employee in a 401(k) plan. In a nutshell, if the participant
in question is properly enrolled no later than three months following the
initial failure, then no corrective contribution is required for the missed
deferral opportunity. However, matching contributions (if applicable), including
earnings, are required as well as a notice to affected participants.
If the failure is discovered beyond three months but less than two years (the
end of the self-correction period) after the failure, a qualified nonelective
contribution will be required for the missed deferral opportunity. The
percentage of compensation to be contributed for the missed deferral opportunity
is calculated by multiplying the average deferral percentage of the excluded
employee’s group (either HCE or NHCE) by 25%. Matching contributions (if
applicable), earnings on the corrective contributions and a notice to affected
participants are also required.
A plan sponsor should never automatically assume that part-time employees are
not eligible to participate in its 401(k) plan. Plan document provisions should
be reviewed and administrative practices put in place to ensure part-time
employees who meet the minimum service requirement are timely enrolled in the
If it is discovered that part-time employees have been improperly excluded,
the plan sponsor should consider using the IRS pre-approved program to correct
the failure and make the participants whole to avoid stiff penalties or possible
This newsletter is intended to provide general
information on matters of interest in the area of qualified retirement plans and
is distributed with the understanding that the publisher and distributor are not
rendering legal, tax or other professional advice. Readers should not act or
rely on any information in this newsletter without first seeking the advice of
an independent tax advisor such as an attorney or CPA.