The basics of employee length of service in 401(k) plans

Managing a qualified retirement plan revolves around accurately counting an employee's length of service. Length of service in a 401(k) plan refers to the total time an employee has worked for an employer. Service can affect a participant’s eligibility to defer into the plan, receive contributions, and increase their vesting of employer contributions. 

While tracking service may seem straightforward, the rules are complex and can present challenges for employers. That’s because measuring service can differ based on the provisions of your plan document. 

This article reviews the differences in counting service for eligibility, vesting, and allocations for qualified plans and review the different methods for calculating length of service. Each has advantages and disadvantages, depending on the plan sponsor and the business. Learning how to properly calculate length of service can help reduce the risk of operational failure.

Plan eligibility

Eligibility refers to the criteria employees must meet to participate in the retirement plan and is stated in the plan document. For 401(k) plans, the maximum eligibility is a year of service (measured as 1,000 hours worked in a 12-month period or 12 months of elapsed time) and age 21. However, documents may allow for a shorter eligibility period. SECURE 2.0 requires plans to allow long-term, part-time employees to participate in the plan if they work 500 hours in three consecutive 12-month periods in 2024 or two consecutive 12-month periods in 2025. 

The plan document will also define the Eligibility Computation Period (ECP), or the period in which you count service to determine if the participant has met eligibility requirements. The first ECP always refers to the first twelve months of service starting on the participant’s date of hire. The following ECPs either continue based on the participant’s hire date or move to the plan year, as stated in the plan document. Most plans move the ECP to the plan year in order to simplify annual reporting and eligibility calculations.

Allocation conditions

Some plans require participants to meet certain conditions on an annual basis to receive employer contributions. These conditions may require the participant to work a certain number of hours, be employed on the last day of the plan year, or both. It’s important to understand how to measure this service so that employer contributions are allocated correctly. 

Vesting service

Vesting refers to the percentage of the employer account of which an employee has earned the right to receive at termination or retirement. Vesting years of service are defined in the plan document and are calculated annually. They can be calculated on a plan year or employment anniversary basis.

Methods of counting service hours

Actual hours method

As its name suggests, the actual hours method measures the number of actual hours the employee worked. Plan documents may vary, but most include all hours for which an employee is entitled to payment, including vacation, illness, jury duty, and leave of absence. Payroll records are relied on to provide accurate hours to plan recordkeepers each year, which assists with calculating eligibility, vesting, and reviewing any allocation conditions. 

Although counting hours may seem simple, it can create potential problems for salaried workers or other employees who may not have documented hours worked. In these cases, it’s not proper to estimate hours. Instead, the plan sponsor should adopt an equivalency method of counting hours.

Equivalency method

The equivalency method of counting hours is a simplified way of determining hours worked for employees who don’t have their hours tracked. The following equivalencies are permissible and the one used must be stated in the plan document:

• 10 hours for each day worked

• 45 hours for each week worked

• 95 hours for each semi-month worked

• 190 hours for each month worked

Although equivalency methods may provide an easier way to track hours, the resulting number of hours tends to be larger than if the participant had actual hours that could be counted. This is in part because based upon the equivalency chosen, if a participant works any part of the period, they are credited for the entire period’s hours. 

Example: The plan document provides for weekly equivalency. If an employee only works only one day of a five-day work week, they are still credited with 45 hours for that week.

The plan document may allow the use of an equivalency method for some employees and the actual method for others. When the plan sponsor designs the plan, it is important to know if they need to use an equivalency for some employees so it is properly included in the plan document. If an equivalency is used, the plan sponsor and/or recordkeeper must understand which employees it applies to. 

Elapsed time method

The elapsed time method is considered the easiest method of counting service. It does not use hours at all. Instead, it simply credits a year of service on the employee’s work anniversary date, regardless of hours worked. If an employee is employed on their anniversary date, they receive credit for a year of service, even if they had periods of unemployment during this year. 

Example: The plan has a six-month eligibility requirement using the elapsed time method of counting service. Employees who are employed six months after their anniversary date are treated as having a year of service, regardless of the number of hours they have worked. 

This method can be useful for employers who don’t want to track actual hours and for employees with fluctuating work hours or non-traditional schedules. However, employers with a large number of rehires or seasonal employees may find that using the elapsed time method for eligibility or vesting is too expensive and prefer to use the hours of service method instead.

When using elapsed time, a special rule (the “Service Spanning Rule”) measures service for rehired employees. This rule requires that an employee who has been gone less than 12 months be credited with service as though they were actually employed. 

Practical considerations and challenges

When counting service hours, it’s important to follow the method outlined in the plan document, and to provide those hours when requested by your service provider or recordkeeper. Service providers need this information when administering your plan’s eligibility, allocation (if applicable), and vesting provisions. If the service provider does not have correct service information when administering the plan, a variety of errors may occur, which must then be corrected, putting the plan at risk of audit. For example, without correct service data, the plan may fail to allow eligible employees to enroll. To correct this, the employer may have to fund a qualified non-elective contribution (QNEC). Another example is using the wrong vesting for a participant who takes a distribution. The participant may receive a larger or smaller distribution than they are entitled to. To correct this, the plan may need to make an additional contribution, recoup funds from plan forfeitures, or request the participant return funds to the plan. 

Plan sponsors have flexibility in choosing methods to count 401(k) service hours, but they must specify these methods in their plan documents. That’s why it's important to review these documents regularly to ensure they are understood correctly. Refer to our guide for more information on 401(k) plan design.