The basics of 401(k) plan eligibility

There are important requirements to consider when deciding on the eligibility of highly-regulated qualified retirement plans such as a 401(k). Picking the right ones to match your employee’s needs is an essential part of the 401(k) plan design process.

Offering a 401(k) plan may lead to lower turnover rates for small to medium-sized businesses across the board. And your plan’s eligibility may impact your company’s employee recruitment and retention efforts.

But choosing your plan’s eligibility doesn’t have to be overly complicated. Below, we take a closer look at these requirements—and outline common eligibility terms—so you better understand how to make the right choices for your plan’s eligibility provisions. 

What is eligibility? 

Eligibility refers to certain conditions that must be met by employees before they’re allowed to participate in a qualified retirement plan. The plan sponsor determines what eligibility will be for its plan, within parameters set by law.

What restrictions apply to eligibility?

The Internal Revenue Code and ERISA dictate who can be excluded from plan participation. A retirement plan may exclude employees under age 21 and/or those who have not worked for the employer for one year. A plan may also exclude certain union employees and nonresident aliens (employees who are not residents of the US and who do not get paid on a US payroll). A plan may also exclude other classifications of employees if the exclusion is: 

1. Based on a reasonable business reason

2. Not tied specifically to the number of hours the employee is scheduled to work

3. The plan can still pass testing under IRC Section 410(b) (“coverage testing”) 

Note: The law places limits on the exclusion of part-time employees as well (more on this later).

Common eligibility terms : what's the waiting period to start a 401(k)?

A plan can always be designed to use the maximum permissible exclusions discussed above. However, plan sponsors may find that allowing employees to participate in the retirement plan sooner is advantageous. For example, rather than require an employee to wait a full year before becoming eligible to participate, a plan sponsor may choose to allow employees to participate after six months, three months—or even immediately. Plan sponsors 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.

Eligibility terms: age requirements

A common eligibility factor to consider is an employee’s age. IRS data from 2012 shows:

• 20% of plans have no age requirement for participation

• 13% of plans have 18 years as the required minimum age

• 4% of plans have 19-20 years as the required minimum age

• 64% of plans have 21 years as the required minimum age 

According to the IRS, generally an employee must be enrolled in a qualified retirement plan if he or she is at least 21 years of age and has completed one year of service. But keep in mind that the employer has the option to set or remove the age requirement if they so choose.

Eligibility terms: Length of service

Another important factor to consider is how the plan will measure service. The law permits a plan to measure service based on either: 

• Elapsed time method (meaning the mere passage of time) could help bring more people into the plan faster and may reduce the complexity of plan administration.

• Actual hours method requires the plan to measure service in actual hours that an employee works within a specific time frame. This may bring fewer people into the plan and could be more complex to administer.

Plan sponsors typically want to minimize administrative work, while still maintaining a 401(k) that’s attractive to prospective talent. If an employer is able to attract top talent that stays a long time, it might be open to letting employees access the 401(k) plan immediately. However, if they tend to have higher turnover, offering shorter 401(k) eligibility criteria to employees that might leave after a few months could result in a heavy administrative burden over time.   

What eligibility terms are common?

According to a study from 2016, the two most common choices companies make when choosing a time requirement are: one year of service (50.42% of plans) and no time requirement (i.e., “immediate eligibility”) (22.44% of all plans). Companies with high turnover, or those that wish to exclude the number of seasonal employees eligible to participate, may prefer a one-year eligibility period (using either elapsed time or actual hours, with actual hours being the most restrictive option). However, companies that wish to help their employees save for retirement as soon as possible, or recruit top talent, might go with a shorter or no wait time. 

What’s an entry date?

Once an employee satisfies the plan’s eligibility requirement, they may enroll in the plan on the next entry date, which is stated in the plan document.

The plan’s entry dates can be any dates that are not later than the statutory entry date (e.g, the earlier of the first day of the next plan year, or the date that’s six months after the age and service requirements are satisfied). An employer that wants to use the maximum hold-out period may choose to use the first day of the plan year and the first day of the seventh month of the plan year as entry dates. This method ensures that entry is never postponed beyond the statutory entry date. However, it’s much more common to see entry dates such as every day (immediate), or the first day of each month. 

Example: If the plan’s eligibility provision requires three months of service, and an employee is hired on January 15, the participant will have satisfied eligibility on April 15. If the plan uses immediate entry, the participant may enter the plan on April 15. If the plan uses a monthly entry date, the participant may enter on May 1. Finally, if the plan uses a quarterly entry date, the participant may enter on July 1st.

Eligibility for part-time employees

The law does not allow part-time employees to be excluded as a classification unless the plan uses a “dual eligibility” provision of 1,000 hours of service. This means part-time employees may be excluded from participation if the plan allows a part-time employee who actually works 1,000 hours in the eligibility measuring period to participate. 

• The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 expanded eligibility for part-time employees to include “long-term, part-time employees.” For plan years beginning January 1, 2024, 401(k) plans must allow certain part-time employees to participate with respect to elective deferrals if they complete three consecutive years of employment with at least 500 hours of service in the twelve-month eligibility measuring period (i.e. a long-term part-time employee).  

The SECURE Act doesn’t require plans to allow long-term, part-time employees to participate in an employer match or profit-sharing contributions. However, some employers will choose to use a single eligibility rule for all plan contributions for simplicity’s sake.

Additionally, new retirement reform legislation proposed in October 2020, often referred to as SECURE Act 2.0, includes a provision that would reduce the three-year rule to two years if it becomes a law without modification. (SECURE Act 2.0 was passed by the House of Representatives in March 2022 and headed to the U.S. Senate for a vote.) 

What’s the difference between 401(k) vesting and eligibility? 

Vesting refers to the portion of an employee's account balance that belongs to them. Employee deferrals are always 100% immediately vested, meaning they always belong to the participant. Safe harbor contributions made by the employer are also 100% immediately vested (except in certain QACA plans). 

Employer contributions (i.e., non-Safe Harbor match or profit-sharing contributions) may be subject to a vesting schedule, or the amount of time it takes a participant to earn ownership of contributions. Vesting is based on an employee’s “years of service.” Most plans call for one year of service to equal 1,000 hours worked in a plan year, but plan documents vary. Employees may become eligible to participate in their company’s 401(k) plan well before they become eligible to vest in their employer contributions. 

There are three types of vesting schedules:

1. Immediate: The employee is entitled to 100% of the employer contributions immediately upon receipt of the contribution.

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

3. Graded: The most common vesting schedule, in which a participant earns a portion of their employer contributions for each year of service they earn. The maximum number of years before a participant can be 100% vested is six. Most plans use a six-year graded schedule where the employee earns 20% of their account each year—after year one—and is 100% vested in year six.

The portion of employer contributions in which an employee does not vest (or “earn”) is forfeited upon distribution of the account. Forfeitures can be used by the employer to pay for plan fees, reduce future employer contributions, or be reallocated to eligible participants as a match or profit-sharing.

Know your small business retirement plan options

Choosing the right 401(k) plan and eligibility requirements at the plan design phase can have a positive impact on a company’s employment goals. However, there’s no one-size-fits-all plan. When requirements are too generous, administrative costs may add up for a business. When they’re too strict, employees might move on to other companies with stronger incentives. 

Human Interest offers flexible, customized retirement plans tailored to the needs of small and medium-sized businesses. Whether you’re a small business that plans to stay small or one with high-growth ambitions, Human Interest can help you find a 401(k) plan that can support your business objectives. Click here to start your 401(k) today.