Seyfarth Synopsis: It’s here for your post-Thanksgiving turkey hangover reading pleasure! The Department of Treasury and IRS released on Friday (in the middle of most people’s long holiday weekend) their proposed rules for long-term part-time employees. The proposal answers many of the burning questions we have had since the new eligibility standards first came to be under the SECURE Act back in 2019.
Background
Eligibility of Part-Time Employees
Qualified retirement plans may not, as a plan term, exclude employees from eligibility based on part-time status. However, the Internal Revenue Code (the “Code”) does allow 401(k) plans to exclude employees from eligibility until they have worked at least 1,000 hours in a year. Many 401(k) plans have utilized that rule to exclude employees who work less than that (e.g., part-time employees) from all plan participation, including the ability to make their own salary deferral contributions.
The rules, however, were significantly altered by Section 112 of the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act), enacted on December 20, 2019, and Sections 125 and 401 of the SECURE 2.0 Act of 2022 (SECURE 2.0), enacted on December 29, 2022. Under the SECURE Act and SECURE 2.0, the ability of plan sponsors to exclude part-time employees from making their own salary deferral contributions is restricted by requiring the inclusion of “long-term part-time employees” in 401(k) plans if certain conditions are satisfied.
SECURE Act and SECURE 2.0 Provisions
Beginning in 2024, under the SECURE Act, 401(k) plans are required to permit part-time employees who perform work for at least 500 hours of service over three consecutive years to contribute to a 401(k) plan. SECURE 2.0 expanded part-time employee eligibility even further, providing that employees who work for at least 500 hours of service over two consecutive years must be eligible to contribute to a 401(k) plan beginning in 2025. Employees who meet these eligibility standards are referred to as “long-term part-time” employees, or LTPT employees, throughout.
The rules relating to employer contributions are not changing, however. Employers will not be required to make employer contributions (i.e., matching or nonelective contributions) for LTPT employees (although they will be free to do so).
The Burning Questions
After the enactment of the SECURE Act and SECURE 2.0, a number of lingering questions about the LTPT employee rules remained, and we have been anxiously awaiting guidance from the IRS. Last Friday, the IRS released proposed regulations that would amend the rules applicable to 401(k) plans to provide guidance with respect to LTPT employees. The proposed rules reflect the statutory changes made by the SECURE Act and SECURE 2.0, and address many of the questions that we have been discussing since the enactment of the LTPT employee provisions.
Below is a general summary of the proposed rules, in question and answer format. Note that these are proposed rules, and the IRS has extended a comment period that closes on January 26, 2024.
Overview of Proposed Regulations
Part I. Determining who is a LTPT employee
Who is a Long-Term Part-Time Employee?
Code Section 401(k)(15), which was added to the Code by the Act, did not specifically define a LTPT employee. The proposed rules finally provide us with a definition, generally defining a LTPT employee as an employee who is eligible to participate in a qualified cash or deferred arrangement (“CODA”) solely by reason of having:
- completed two consecutive 12-month periods during each of which the employee is credited with at least 500 hours of service (three consecutive 12-month periods with respect to the 2024 plan year); and
- attained age 21 by the close of the last of the 12-month periods.
As expected, the proposed rules clarify that LTPT employees do not include certain classifications of employees, such as certain collectively bargained employees and nonresident aliens who receive no U.S. source income. The IRS notes, however, that there is no exception for a qualified CODA under (i) a governmental plan, or (ii) a church plan that has not elected to have the participation, vesting, and funding provisions apply. The IRS specifically requests comments with respect to the application of the LTPT employee rules to governmental plans and church plans.
May plans continue to exclude certain employees from participating in a 401(k) plan, even if they work 500 hours over the applicable number of consecutive 12-month periods?
Yes. As we suspected, in the proposed rules the IRS confirms that an individual who otherwise would be eligible to participate in the plan as a LTPT employee may be excluded from participating if the employee is a member of a job classification that is not based on age or service and whose members are excluded from participating under the terms of the plan. For example, employees of a particular division may be excluded from participating in the plan, even if they satisfy the LTPT employee rule, provided exclusion of the division is not based on age or service.
Note that the proposed rules generally provide, however, that with the exception of periods of employment before January 1, 2021, all 12-month periods during which an employee is credited with at least 500 hours of service with an employer must be taken into account for purposes of determining LTPT employee eligibility, including periods an employee is in a classification of employees who are ineligible to participate in the qualified CODA (e.g., employees of a specified division of the employer.) This is generally consistent with the service crediting rules that currently exist.
Who is NOT a LTPT Employee?
Most importantly, the proposed regulations tell us who is not a LTPT employee. Specifically, the proposed rules provide that the LTPT employee rules under Code Section 401(k)(15) only apply to employees who become eligible to participate in a qualified CODA solely on account of having completed the applicable number of consecutive 12-month periods during which the employee is credited with at least 500 hours of service.
In other words, the rules do not apply to an employee who became eligible for a 401(k) plan by reason of having completed any other service requirement, or an employee who is immediately eligible to participate in the plan. Nor do the rules apply to an employee who becomes eligible to participate in a plan under the elapsed time method, as described in more detail below.
Will all 401(k) plans be required to count hours for eligibility purposes?
No. One lingering question since the SECURE Act was enacted has been how the LTPT employee rule will apply to a plan that does not count hours for purposes of determining whether an employee is eligible to participate. In other words, how does the rule apply to plans that use the elapsed time method to determine eligibility to participate, or to plans that use equivalency methods to credit service? The proposed rules address these questions:
- Plans That Use the Elapsed Time Method. Under the elapsed time method, an employee is eligible to participate after completing a one-year period of service, without regard to hours worked. The proposed rules would allow plans to continue to use the elapsed time method to determine eligibility to participate. However, a plan may not require an employee to complete more than a 1-year period of service under the elapsed time method.
The regulations make it clear that an employee who becomes eligible to participate in the plan under the elapsed time method would not be eligible to participate solely by reason of completing the applicable number of consecutive 12-month periods with at least 500 hours of service during each period and would not be a LTPT employee. Presumably, this is because an employee is better off under the elapsed time method because they are eligible after completing 1-year of service, as opposed to completing 500 hours of service during the applicable number of consecutive 12-month periods of service.
- Plans that Use Hours Equivalency Methods. The proposed regulations permit the use of equivalency methods to credit hours of service and determine whether someone is credited with at least 500 hours of service during a 12-month period (e.g., 190 hours for each month an employee would be required to be credited with at least one month of service). In addition, the rules do not reduce or otherwise alter the number of hours that would otherwise be credited to an employee under the applicable equivalency method.
Employers that sponsor 401(k) plans that do not count actual hours worked for purposes of eligibility can breathe a sigh of relief, in that the proposed regulations confirm that plans using the elapsed time method or an hours equivalency method to determine eligibility to participate will not be required to start counting hours of service.
When must LTPT employees start participating in the plan after satisfying the rule?
The proposed rules confirm that the same entry date rules that apply to other eligible employees also apply to LTPT employees. In other words, a LTPT employee must become eligible to make a salary deferral election no later than the earlier of (i) first day of the first plan year beginning after the date such employee satisfied the eligibility requirements; or (ii) the date that is 6-months after the date on which he satisfied such requirements.
How is the initial 12-month period measured? What about subsequent 12-month periods?
The proposed rules make it clear that the initial 12-month period must begin on an employee’s date of hire (the date the employee first begins to perform service for the employer). However, the plan may provide that subsequent 12-month periods are determined by reference to the first day of the plan year.
What if a LTPT employee subsequently works less than 500 hours in a 12-month period? Will they cease to be eligible to make elective deferral contributions?
No. The proposed rules do not include any provisions similar to the break in service rules under Code Section 410(a)(5). In other words, a LTPT employee’s eligibility to participate is not impacted by the employee’s completion of one or more 12-month periods during which he or she works less than 500 hours of service. For example, a LTPT employee who begins participating in a 401(k) plan in 2024 does not cease to be a LTPT employee in 2025 if he or she completes less than 500 hours of service in 2024.
Part II. Vesting Rules for LTPT Employees
What special vesting rules apply to LTPT employees?
As mentioned above, the eligibility rules relating to employer contributions have not changed, so employers are not required to make employer contributions for LTPT employees when they are eligible to participate beginning in 2024. However, the SECURE Act and SECURE 2.0 included special vesting rules that apply to LTPT employees.
The proposed rules clarify that a LTPT employee (or a former LTPT employee, discussed below) must be credited with a year of service for purposes of vesting for all 12-month periods during which the employee had at least 500 hours of service (as opposed to the 1,000 hours requirement that is used by many plans with a vesting schedule) with respect to employer contributions. Periods beginning before January 1, 2021 are not taken into account for purposes of this rule. This special vesting rule applies only to LTPT employees (or former LTPT employees) who become eligible to participate in a plan solely on account of this new rule (and not all employees or plan participants). The proposed rules also clarify that the vesting computation period is not required to be the same as the employee’s eligibility computation period, so long as the vesting computation period is the calendar year, the plan year, or another 12-consecutive month period designated by the plan.
What vesting rules apply if a LTPT employee subsequently works 1,000 hours?
Under the proposed rules, if an employee becomes eligible to participate in a plan solely on account of the LTPT employee rule, but later completes a year of service under the plan’s regular eligibility standard, they then become a “former LTPT employee.” Former LTPT employees continue to be credited with a year of vesting service for any 12-month period during which the former LTPT employee is credited with at least 500 hours of service with the employer(s) maintaining the plan. In other words, a former LTPT employee who has become a full-time employee would not flip to the 1,000 hours of service requirement for vesting purposes if used by the plan for eligible employees other than LTPT employees.
Query: The proposed regulations do not specifically address in the examples a situation where a LTPT employee is not eligible to receive employer contributions under a plan until the employee completes a year of service (e.g., 1,000 hours of service). For example, assume in that situation employer contributions are subject to a vesting schedule that requires an employee to complete 1,000 hours of service during a 12-month period in order to earn one year of vesting service. Further assume that the LTPT employee subsequently becomes eligible for employer contributions after completing a year of service. Once the LTPT employee has a year of service and becomes eligible for employer contributions, does the 500 hour of service rule apply to the vesting of those contributions, or the 1,000 hour of service rule?
Based on the proposed rules, it would appear that the employee in this scenario is a former LTPT employee who would receive credit with a year of vesting service for any 12-month period during which the former LTPT employee is credited with at least 500 hours of service with the employer(s) maintaining the plan. It does not seem to matter that the employee was not eligible to receive employer contributions as a LTPT employee, so long as the employee becomes eligible to participate in a plan solely on account of the LTPT employee rule. As a result, the former LTPT employee would be treated more favorably than the employee working more than 1,000 hours of service.
Part III. Exclusion of Long-Term Part-Time Employees from Nondiscrimination and Coverage Testing and Top-Heavy Testing
May LTPT employees be excluded from nondiscrimination and coverage testing?
Yes, the proposed regulations confirm that employers may elect to exclude LTPT employees from the following nondiscrimination and coverage tests (the “Tests”): (1) nondiscrimination requirements under Code Section 401(a)(4), (2) ADP test under Code Section 401(k)(3), (3) the ACP test under Code Section 401(m)(2), (4) ADP safe harbor provisions under Code Sections 401(k)(12) and (13), (5) the ACP safe harbor provisions under Code Sections 401(m)(11) and (12), and (6) the minimum coverage requirements under Code Section 410(b). Former LTPT employees, however, may not be excluded from these Tests.
For example, safe harbor plans intended to satisfy the ADP and/or ACP safe harbor provisions will not fail to satisfy those provisions merely because the employer elects not to make safe harbor contributions on behalf of LTPT employees. However, as described below, the employer must elect to exclude them (see discussion below).
In response to a comment received, the regulations clarify that an employer election to exclude LTPT employees applies for purposes of every Test listed above. Also, it must apply to all LTPT employees. In other words, employers may not pick and choose which Tests from which to exclude LTPT employees and/or which LTPT employees to include or exclude in the Tests.
What, if anything, must employers do if they want to exclude LTPT employees from testing, and employer matching or non-elective contributions?
If the plan is a safe harbor plan, it must be amended to include language clearly providing that LTPT employees are excluded for purposes of the Tests, as well as any ADP and/or ACP safe harbor provisions that would otherwise apply to eligible employees. The proposed rules provide that this language would need to be adopted before the beginning of the plan year.
Query: So when must plans be amended to include this language? Please note this year-end deadline in light of the fact these rules are still proposed and comments are not even due until 2024, and the SECURE 2.0 general amendment deadline of December 31, 2025.
For non-safe harbor plans, the proposed rules do not require that the election be set forth in the plan document. However, the rules provide that the terms of the plan need to provide “enabling language.” The proposed rules do not provide any examples of what “enabling language” might look like. Plan sponsors should review their plan language with counsel to determine if any amendment may be required this year.
May LTPT employees be excluded from top-heavy testing?
LTPT employees must be included under Code Section 416(g) to determine whether a plan is top-heavy. Consistent with SECURE 2.0, the regulations make it clear that a plan will not fail to be excluded from the definition of a top heavy plan merely because the employer does not make nonelective or matching contributions on behalf of LTPT employees. However, the proposed rules clarify that LTPT employees may be excluded from the top-heavy vesting and benefit requirements under Code Sections 416(b) and (c) at the election of the employer (see below).
What, if anything, must employers do if they want to exclude LTPT employees from application of the top-heavy vesting and benefit requirements?
The employer election regarding top-heavy benefits is separate from the election described above relating to the Tests. The terms of the plan must be amended to specifically provide that LTPT employees are excluded from the application of the vesting and benefit requirements of Code Sections 416(b) and (c).
If an employer makes matching and/or nonelective contributions on behalf of LTPT employees may they still be excluded from testing and/or top heavy benefits?
Yes, employers may elect to exclude LTPT employees from the Tests and/or top heavy benefits even if these employees are eligible to receive employer match and/or nonelective contributions. In other words, if elections are made by employer as described above, then any employer contributions made on behalf of LTPT employees for the plan year are disregarded for purposes of determining whether the Tests are met and application of the top heavy vesting and benefit requirements. This clarification in the proposed regulations was in response to a comment received.
Part IV. Other Items
Do LTPT employees have to be eligible to make catch-up contributions and/or Roth deferrals?
No. The proposed rules clarify that LTPT employees may be permitted to make catch-up contributions and Roth contributions. However, an employer electing to exclude LTPT employees from Testing could prohibit these employees from making catch-up and/or Roth contributions and not run afoul of these Testing requirements.
Are employers required to include LTPT employees when determining whether a plan is required to perform an annual audit in connection with the Form 5500 filing?
Unknown. In general, defined contribution plan sponsors must include an audit report with the annual Form 5500 unless the plan is a small plan with fewer than 100 participants at the beginning of the plan year. The current rule counts those who are eligible to participate even if they have not elected to participate and do not have an account in the plan (beginning January 1, 2023, defined contribution plans must only consider the number of participants with account balances as of the beginning of the plan year when determining whether it is a small plan).
The proposed rules provide that commentators requested that LTPT employees be excluded for purposes of determining whether a plan is a small plan exempt from the audit report requirement. In response, the preamble to the proposed rules provides that the annual audit report requirement falls under the regulatory and interpretive authority of the Department of Labor, and is outside the scope of the proposed regulations.
Part V. Next Steps
We will continue to study the proposed regulations, and have reached out to the IRS with some questions. Comments are due by January 26, 2024 and more guidance should be available after that deadline. The rules are complex, so please tune into our Coffee Talk With Benefits Podcast where we will be discussing the proposed rules on LTPT employees (as well as other interesting topics!) in more detail.
