Co-authored by Alex Baker, CPA
Plan sponsors have more flexibility than they may realize when it comes to setting eligibility rules for 401(k) plan participants. Even though ERISA sets many rules for eligibility, plan sponsors have leeway to meet the demands of the employment market. Here are some thoughts for plan sponsors to consider when determining plan enrollment.
When to be generous
ERISA doesn’t dictate how generous you can be regarding enrollment. So if you want to make all new hires eligible to participate and receive fully vested employer matches from day one, you won’t encounter any legal difficulties. There are, however, sound reasons you might not want to take that approach.
Generally, in a tight labor market prospective employees expect competitive 401(k) benefits. For sponsors, turnover is lower and plans aren’t urgently trying to minimize 401(k) expenses. In this scenario, plan sponsors may want to be more liberal with eligibility requirements.
And even if the employment market isn’t tight, some businesses have higher turnover rates than others. If you routinely experience high turnover, allowing new hires to join the plan right off the bat may lead to needless administrative effort, possible errors and higher administrative costs. You could wind up having to distribute many small 401(k) balances to participants who left within a year, or maintain those legacy accounts until former participants request a rollover.
Limits on limits
Many plan sponsors find a happy medium somewhere between immediate enrollment and highly restricted or delayed enrollment. ERISA restricts your ability to limit eligibility in multiple ways:
Age restriction. You don’t have to enroll employees below the age of 21, but you cannot have an age requirement over such age. This may or may not have an impact, depending on your workforce demographics. Many plans either have no age requirement or use age 18 as the minimum age.
Delayed gratification.You can require employees to wait up to 18 months to enter the plan. This is accomplished by requiring employees to work at least 1,000 hours over the course of a 12-month period to gain eligibility. The plan then provides that, once eligibility is met, entry into the plan is the next semiannual entry date. For example, suppose your plan is a calendar year plan. You hire Jane on July 2, 2016, and she completes one year of service and the 1,000 hour requirement by July 2, 2017. She would enter the plan as of January 1, 2018.
Category-based standard. Plan sponsors can assign different standards for exempt vs. nonexempt employees. For example, you could set more generous eligibility rules for exempt employees than nonexempt employees. You might want to do so if the labor market is tight for the types of jobs your exempt employees hold, but not your nonexempt employees.
However, your ability to establish these job classification distinctions is limited by your need to satisfy IRS coverage tests. These tests are designed to prevent discrimination against lower-paid workers. For example, the percentage of participating nonhighly compensated employees (NHCEs) cannot be less than 70% of the participation rate of highly compensated employees (HCEs). In addition, the average benefits received by NHCEs must equal at least 70% of benefits received by HCEs. The average benefits test also features a more subjective nondiscriminatory classification component.
You can also create different eligibility rules for union and nonunion jobs, and those distinctions, like the delayed eligibility timing tactic, aren’t subject to the minimum coverage tests.
Make the choice
Restricting 401(k) plan participation eligibility isn’t for everyone. And be aware that, if new employees don’t get on the 401(k) bandwagon early, they might be less inclined to participate later when they’re eligible. This could lead to problems with other discrimination tests, namely those comparing deferral rates of NHCEs to HCEs. Still, for some employers, a restrictive eligibility strategy may prove useful.
Whenever considering plan design options, it’s important to work with experienced consultants who can advise you on the options available, as well as what may work best for your company given your objectives and employee demographics. Give us a call; we're here to help.