QUESTION: We would like to amend our 401(k) plan to exclude all part-time employees from plan eligibility, regardless of their hours. Can we do that?
ANSWER: Employers have considerable freedom to decide which categories of employees can participate in their 401(k) plans, but that freedom is not unlimited. For example, eligibility restrictions must avoid violating the Code’s minimum coverage rules. And service-based exclusions cannot violate the minimum service rules. Under those rules, employees generally cannot be required to have more than 1,000 hours of service in a designated 12-month period prior to participating. In addition, long-term part-time employees cannot be required to have more than three consecutive 12-month periods of at least 500 hours of service before they can make elective deferrals. (Deferrals are not required under the three-year rule prior to 2024, however, because only 12-month periods after 2020 must be counted.)
Your question indicates that you would like to exclude all part-time employees regardless of their actual service. That sort of categorical exclusion might seem different from an hours of service requirement, but if your company is like many employers, part-time status may be based on anticipated or scheduled service. And in the IRS’s view, a service-based eligibility threshold that does not count actual hours of service will still fail the hour-counting rules if, in operation, it excludes employees whose actual service satisfies an applicable hour-counting threshold. For example, if your plan were to define part-time employees as employees who are “regularly scheduled” to work 20 or fewer hours a week, the plan might end up excluding employees who actually work 20 hours a week for 52 weeks and therefore have 1,040 hours of service for the year. In that event, your plan would be using a service-based threshold to exclude employees who in fact have satisfied the Code’s 1,000-hour minimum service rule. And beginning in 2024, employees with even fewer hours will not be excludable from elective deferrals on account of their service if they actually worked at least 500 hours in three consecutive 12-month periods.
One approach to excluding employees who are not full-time is to look for a common denominator among the employees that you wish to exclude—such as job function or job location—that is not service-based. For example, if most of your part-time employees are performing the same job function or work at the same location and you are willing to exclude all of your other employees who perform the same job function or work at the same location, you may be able to craft a rule that excludes those part-time employees without violating the Code’s minimum service rules. Be careful, though, because at least one IRS representative has indicated that even criteria that are not service-based may violate the Code if they merely disguise an improper service rule. Finally, we note that errors in applying the eligibility rules to part-time employees frequently turn up in voluntary compliance and IRS audits. It is critical that the plan’s terms clearly state your company’s design choices, especially when excluding certain classes of employees. Moreover, you should routinely review plan language to ensure that it reflects changing employment practices.
For more information, see EBIA’s 401(k) Plans manual at Sections VII.C (“Eligibility Condition #2: Participation Limited to Class of Eligible Employees Defined in Plan”), VII.D.2.d (“Minimum Service Requirement: Long-Term Part-Time Employees”), XXXII.D (“Voluntary Compliance Audits”), and XXXIV.E (“Correcting Plan Mistakes: Errors Involving Eligibility”).
Contributing Editors: EBIA Staff.