Just In Time: IRS Proposes Regulations on 401(k) Eligibility for Long-Term Part-Time Employees

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Following the Thanksgiving holiday, the Internal Revenue Service (“IRS”) made employers and third-party retirement plan administrators (“TPAs”) very thankful by issuing long-awaited proposed regulations (set forth in Treas. Reg. Section 1.401(k)-5) on the long-term, part-time employee eligibility rules established under the SECURE Act of 2019 (“SECURE Act 1.0”) and the SECURE Act of 2022 (“SECURE Act 2.0”). Despite issuing the proposed regulations with only a month to go before the underlying rules become effective, the proposed regulations answer many implementation questions and are welcomed relief for many plan sponsors and TPAs. Plan sponsors can rely on the proposed regulations in advance of the IRS issuing final regulations sometime in the future.

Background

As background, prior to SECURE Act 1.0, the Internal Revenue Code’s rules for qualified cash or deferred arrangements provided that plans could not require employees to complete a service period greater than what was prescribed under Internal Revenue Section 410(a)(1) (i.e., the later of age 21 or the completion of a 12-month period during which the employee has at least 1,000 hours of service). This changed with SECURE Act 1.0, which mandates employer-sponsored 401(k) plans allow employees who are considered long-term part-time (“LTPT”) employees to participate in the plan for the purpose of making elective salary deferrals beginning as of January 1, 2024 (and for non-calendar year plans, the beginning of the plan year that begins on or after January 1, 2024). For this purpose, a LTPT employee is any employee who: (i) is 21 years old and completes at least 500 hours of service in each of three (3) consecutive 12-month computation periods (i.e., 2021, 2022, and 2023); and (ii) is not covered under a collective bargaining agreement or a nonresident alien with no US-source income. SECURE Act 2.0 expanded this mandated coverage for LTPT employees by reducing the required number of years of service (with at least 500 hours each year) from three (3) consecutive years to two (2) consecutive years, beginning as of January 1, 2025 (and for non-calendar year plans, the beginning of the plan year that begins on or after January 1, 2025). Neither SECURE Act 1.0 and 2.0 require employers to allow LTPT employees to participate in the 401(k) plan for the purpose of receiving any employer contributions (e.g., matching, profit-sharing contributions). SECURE Act 2.0 expanded the LTPT employee rules to cover employer-sponsored 403(b) plans. 

Proposed Regulations & Guidance

While the regulations are not yet final, they provide plan sponsors and TPAs with a good idea of how the IRS will fill in the gaps on these rules and what will comprise the final regulations. Key takeaways from the proposed regulations are detailed below.

LTPT Employee Specifics: The proposed regulations make it clear that the LTPT rules apply to those employees who become eligible to participate in the plan by virtue of satisfying the LTPT eligibility rules specifically (i.e., being age 21 and completing 500 hours of service for 3 (or 2) consecutive 12-month periods). As such, if an employee is eligible to participate by virtue of satisfying the plan’s other service requirements (e.g., 1,000 hours of service), or by being eligible immediately, the employee will not be considered a LTPT employee subject to the LTPT rules (rather, he or she will be eligible to participate in the plan in the same manner as any other regular participant).

The proposed regulations also explain that a LTPT employee will cease to be a LTPT employee (and will instead be a “former LTPT employee”) on the first day of the first plan year beginning after the earlier of the year in which the employee (i) completes 1,000 hours of service in a 12-month period (the plan’s maximum allowable waiting period), or (ii) becomes an ineligible employee (based on falling into an excluded class unrelated to age or service).

Class Exclusions: Since the enactment of SECURE Act 1.0, one of the most popular questions from plan sponsors has been whether plans could continue to exclude certain classes of employees from participating in their plan (even if the employees otherwise would satisfy the LTPT eligibility rules). The IRS confirmed that valid class exclusions (e.g., certain job positions or geographic locations) are permitted under the LTPT rules; however, a class exclusion cannot serve as a proxy for imposing a prohibited age or service requirement. Essentially, plan sponsors cannot use a “disguised” age or service condition (through a class exclusion) to exclude employees from becoming eligible LTPT employees based on how much the work (e.g., part-time, seasonal, temporary employees). For example, it will likely be in violation of the LTPT rules if an employer plan sponsor excluded all seasonal employees from participating in the plan regardless of whether or not they satisfy the LTPT eligibility requirements.

Entry Date: When an employee is determined to be a LTPT employee who is eligible to participate in the plan, he or she must be allowed to enter the plan no later than the earlier of the first day of the first plan year beginning after: (i) the date the LTPT employee satisfies the eligibility requirements, or (ii) the date six (6) months after satisfying the eligibility requirements. This is a baseline for plan sponsors; alternatively, plan sponsors can utilize the same entry date for all participants, including LTPT employees.

Counting Hours of Service: The proposed regulations provide that when determining whether an employee has satisfied the LTPT eligibility requirements (i.e., being age 21 and completing 500 hours of service for 3 (or 2) consecutive 12-month periods), plan sponsors must count all 12-month periods beginning on the later of the employee’s hire date, or January 1, 2021 (including any periods therein where the employee was ineligible). If an employee does not work 500 hours or service from one year to the next, the employee’s LTPT eligibility determination must start over. Once an employee satisfies the LTPT eligibility requirements he or she will remain an eligible LTPT employee (even if he or she subsequently does not continue to work 500 hours) until either: (i) the employee completes 1,000 hours of service in a 12-month period and becomes a regular participant, or (ii) the employee becomes an ineligible employee (based on falling into an excluded class unrelated to age or service), as discussed above.

The proposed regulations confirm that plans that do not count actual hours worked for eligibility purposes will not have to start doing so under the LTPT rules. More specifically, plans that utilize the elapsed time method (which allows an employee to participate after one-year of service regardless of his or her hours) can continue to do so without regard to the LTPT rules, and any employees who become eligible under those elapsed time rules will not be a LTPT employee. Plans that use the equivalency method (e.g., crediting a set number of hours per a certain period) can utilize this method to determine whether an employee satisfies the LTPT’s 500 hours of service requirement during a 12-month period (as long as the equivalency method is set forth in the plan document).

Vesting: If a plan sponsor elects to make employer contributions to LTPT employees (which it is not required to do), it can impose a vesting schedule for those contributions. More specifically, a plan must credit LTPT employees with one year of vesting service if such employees complete 500 hours of service during a 12-month period. For this purpose, a LTPT employee’s service prior to January 1, 2021 is not counted.

Safe Harbor Plans: Plan sponsors can elect to exclude LTPT employees from receiving safe harbor contributions. The proposed regulations confirm that LTPT employees may be excluded from the determination of whether the plan satisfies the safe harbor plan contribution and top-heavy benefit requirements; however, such exclusions should be reflected in the plan document and cannot be changed mid-year. Notably, if an employer elects to exclude LTPT employees from any employer safe harbor contributions, this election will not result in a loss of the plan’s top-heavy exemption.

Testing: Plan sponsors can exclude LTPT employees from the plan’s nondiscrimination and coverage testing (related to employer contributions), provided that LTPT employees are excluded from all such testing (i.e., coverage, ADP, ACP), and such exclusion is reflected in the plan document). If a plan sponsor elects to exclude LTPT employees from testing, it means that LTPT employees (and their contribution rates) will not be considered in any testing calculations. Alternatively, plan sponsors can elect to include LTPT employees in their testing, if desired.

Top-Heavy Benefits: Separately, plan sponsors can exclude LTPTs from their plan’s top heavy vesting and from receiving any top-heavy benefits; however, the exclusion (or inclusion) must apply to all LTPT employees in the same manner. Notably, the IRS has not stated that a plan sponsor can exclude LTPT from the plan’s top-heavy determination (and thus, they should be included in this determination). The proposed regulations did confirm, however, that a plan that excludes LTPT employees from employer contributions will not be considered top-heavy if it is determined to be top-heavy due to the LTPT employees’ exclusion from employer contributions.

Compliance Considerations

Amendments to formally adopt the LTPT rules under SECURE Acts 1.0 and 2.0 are not required until the last day of the first plan year beginning after January 1, 2025 (i.e., December 31, 2025, for calendar year plans); however, plans are required to administratively comply with these provisions as of January 1, 2024. As such, affected plan sponsors should be working with their TPAs and legal advisors to ensure their plans are prepared to permit any eligible LTPT employees to participate (for the purpose of making elective salary deferrals) in 2024. Plans that allow all employees to participate their 401(k) plans (or 403(b) plans) will not need to take any action in order to comply with these new LTPT employee rules.

Employer plan sponsors that do not allow all employees to participate should begin working with their TPAs and recordkeepers immediately to review their excluded and/or ineligible employee populations and determine if there are any employees who may be eligible to participate in the plan beginning on January 1, 2024 as a LTPT employee (i.e., the employee is age 21 and has completed 500 hours of service in three (3) consecutive 12-month periods and is not in an otherwise excluded class, as discussed further above).

Employer plan sponsors affected by the new LTPT rules should also consider preparing and/or updating and distributing communications to affected employees to notify them of their participation rights as soon as possible.