Establishing eligibility requirements for plan participation requires consideration of both the broad range of available options and the potential effects that different sets of eligibility requirements may have on hiring, retention, and administrative costs. Following is a brief overview of the applicable rules.
Conditions of Eligibility
Federal law establishes the limits of what conditions may be set on eligibility. Generally, plans may require employees to attain any age up to 21 years old before they may become participants in the plan. Plans may also require up to one year of service before employees may make elective contributions. If a 401(k) plan also provides for other types of employer contributions (such as matching on nonelective contributions), it may require that employees complete up to two years of service before being eligible to receive these contributions. In such cases, however, the employees must be 100 percent vested in the employer contributions.
1,000 Hours-of-Service Rule
Generally, a “year of service” is a 12-month period during which an employee completes the number of hours of service specified in the plan. A plan may not specify more than 1,000 hours for this purpose.
An employee’s first year of service is measured during a 12-consecutive-month “initial eligibility computation period,” which begins on the employee’s “employment commencement date.” For periods after the initial eligibility computation period, the plan must measure service for participation purposes either during the 12-consecutive-month periods that begin on the anniversaries of the employment commencement date or during the plan years that include such anniversaries.
The elapsed-time method is an alternative for retirement plans to define crediting service for eligibility. In this system, a year of service is completed when the employee completes 12 months or 365 days of service, regardless of how much he or she actually worked during that period. This system is easier to administer because it does not require keeping track of actual or equivalent hours of service during distinct 12-month periods.
Instead, the employer monitors the period beginning with the employee’s date of hire through the date the employee meets the eligibility requirements. This method requires only that the employee be employed on both the original hire date and on the last date of the eligibility period established by the plan.
Effect of Service Spanning Rule
The IRS has service spanning rules that apply under the elapsed-time method. Generally, under these rules, the employee is not
penalized for absences of less than 12 consecutive months. For example, assume a company has a one-year elapsed-time eligibility requirement. If an employee is hired on June 15, 2016, leaves the company on August 20, 2016, and then is rehired on February 10, 2017, he or she fulfills the one-year service requirement since the absence was less than one year.
Setting Eligibility Terms
When choosing eligibility requirements, retirement plan sponsors should consider such issues as the number of part-time employees they have, the goals of their 401(k) plans, and how different eligibility requirements might affect administrative costs. For example, if a company has high employee turnover, it may choose longer service requirements to reduce its administrative burdens. For similar reasons, an employer with numerous part-time employees may wish to avoid the elapsed time method. On the other hand, sponsors may want to consider whether raising the eligibility requirements might make hiring top talent more difficult and/or impair their employees’ ability to prepare for retirement.