401(k) plan design: An overview

Want to offer a 401(k) retirement plan for your employees? Or upgrade the plan you already offer? It’s important to understand the basic components of retirement plan design—and which plan design features will best meet the retirement needs of your employees.

What is retirement plan design?

Designing the right 401(k) plan for your business means matching the features and options of the plan to the goals you want your employees to achieve. Generally, businesses sponsor retirement plans to:

• Help employees prepare for a financially secure retirement

• Maximize owner contributions to retirement accounts

• Support the hiring and retention of high-caliber employees

• Provide tax savings to the business

The weight given to each of these goals will vary from business to business—particularly small to medium-sized businesses—and may change over time as a business expands. But no matter your goals, it’s worth noting that offering a 401(k) plan may lead to lower turnover rates for small to medium-sized businesses, according to Human Interest data from March 2022. 

To start, plan design means checking the right boxes to ensure your plan is set up correctly for your circumstances. Here are the five features employers must review. 

1. Eligibility and vesting

Eligibility

A retirement plan’s eligibility rules determine which employees can participate in the plan, when they can start participating, and when they can begin receiving employer contributions (if a matching or nonelective contribution is offered).

Any conditions that must be met by employees to participate in the plan are determined by the employer and included in the plan document, within parameters set by law. Employers can choose a single eligibility provision that covers all sources offered in the plan (e.g., deferrals, match, profit sharing), or can offer different eligibility requirements for different sources.

According to Vanguard’s How America Saves 2021 Small Business edition, which surveyed plans that Vanguard administers, larger plans were more likely to offer immediate eligibility compared to smaller ones. In fact, only 21% of small businesses offered immediate eligibility.

Why eligibility matters

Legally, a plan must allow employees to participate in a qualified retirement plan after meeting the following requirements:

• Age 21

• One year of service (defined as working 1,000 hours or more in 12 months)

Employers may find that allowing employees to participate in the retirement plan earlier than these requirements is advantageous. However, if an employer tends to have higher turnover, restricting participation to employees who have reached particular milestones—one year, six months, three months of service—might make sense. 

Additional reading: The basics of 401(k) plan eligibility

Vesting

Contributions made by employees to their retirement plans always belong to them. Employer contributions, however, may not initially belong to the employee. “Vesting” refers to the ownership of employer contributions in an employee's retirement account. Employees who leave employment before being fully vested forfeit employer contributions not yet vested.

While many sponsors design their plan to grant immediate vesting on employer contributions, others use a vesting schedule to gradually transition ownership, during which a participant earns ownership over time. There are three types of vesting schedules:

1. Immediate: Employees are entitled to 100% of employer contributions immediately upon receipt of the contribution.

2. Cliff: The employee is 0% vested in employer contributions until they meet a specified number of years of service. Then, they’ve earned 100% of employer contributions in their account. A cliff-type vesting schedule cannot be longer than three years.

3. Graded: With a graded vesting schedule, based on the years of service, an employee keeps a percentage of the employer contributions each year, increasing annually until 100% vested. After six years of employment, all employer contributions must be 100% vested.

Of the small businesses that offered matching contributions in Vanguard’s 2021 survey, 73% offered immediate vesting.

Why vesting matters

Employers must decide what matters most to them when it comes to vesting. Those trying to attract employees will find immediate vesting can help entice candidates to join an organization. Others are more concerned with the cost of employer contributions to the business or about the retention of employees. A cliff or graded vesting schedule may help increase retention for those sponsors that struggle with high turnover rates by encouraging employees to stay at least until they’re 100% vested. They’ll also reduce the sponsor’s cost of providing an employer contribution, preventing employees from working at a business for just a few months and leaving with the employer's contributions. 

Keep in mind that a vesting schedule is more complicated to administer than immediate vesting. 

2. Compensation

Employers may exclude specific types of compensation in calculating employee deferrals and employer contributions, including compensation earned before plan entry and fringe benefits. Other types of compensation (e.g., bonuses, overtime) may be excluded if the document allows; these exclusions may require additional annual nondiscrimination testing.

3. Contributions

A 401(k) plan is a defined-contribution plan, meaning employees contribute a portion of their wages—either a specified dollar amount or percentage of a paycheck—to their retirement account. Participants can update their contribution rate as specified in the plan document. 

Employer contributions are optional in a 401(k) plan. The types of employer contributions may include:

• Employer match: A contribution made by the employer only for employees that choose to make deferral contributions into the plan (i.e., for every dollar an employee saves, the employer fully or partially matches this contribution, up to a certain percentage of the employee’s salary or dollar limit). At Human Interest, 42% of total plans that provide a match offer $1.00 per dollar on the first 4% to their employees, according to internal data from January 2022.

• Safe harbor: Provision that requires employers to make at least a basic matching contribution(see more below) or a 3% nonelective contribution (i.e., an employer contribution to each employee equal to 3% of the employee’s annual compensation, regardless of whether the employee makes deferral contributions). Depending on when a safe harbor nonelective provision is added to the plan, the required percentage may be 4%.

• Profit sharing: Despite its name, profit sharing is not actually tied to an employer’s profitability. This optional employer contribution is provided to all employees, regardless of their deferral election, and is based upon their annual compensation. There are numerous profit-sharing allocation formulas an employer can choose, depending on their goals for the profit-sharing contribution.

Additional Reading:

4. Distributions

A 401(k) distribution occurs when an employee withdraws money from their retirement plan. Rollovers are a special type of distribution, occurring when a plan participant transfers the funds tax-free from their existing retirement account to a new retirement plan or IRA. 

Oftentimes, plans also allow in-service distributions, which is a distribution requested while a participant is still employed by the business. There are multiple types of in-service distributions. They’re all optional, meaning employers can choose whether the plan will permit them or not. 

One in-service distribution option is called a hardship distribution, defined by the IRS as a distribution from a participant’s elective deferral account stemming from “an immediate and heavy financial need.” These distributions are limited to the amount required to meet the participant’s financial needs and are subject to income tax. That’s why it’s important for all plan participants to understand the nuances of a hardship distribution.

5. Loans

Loans are another optional feature that can be added to a 401(k) plan. The ability to take a loan from their retirement plan without incurring taxes or penalties is often popular with employees but adds a layer of administrative work for the employer or their recordkeeper. In 2020, seven out of 10 of Vanguard’s small business 401(k) plans allowed participants to borrow from their retirement plans. For more information, refer to our guide on the topic: Your 401(k) and loans.

Popular plan design features

There are building blocks that serve as the foundation for most traditional 401(k) plans. Beyond the essentials, however, there are popular retirement plan features that employers can add to help their employees maximize the benefits of their 401(k) plans. For example, at Human Interest, we think that automatic 401(k) enrollment combined with automatic escalation and appropriate opt-out provisions in place may help boost both participation and deferral rates. 

If have any questions about plan design—or want to get started with setting up a 401(k) plan for your business—contact us today.

*Amy Johnson is an independent contractor commissioned by Human Interest to help contribute to this article.