The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act of 2019) and the SECURE 2.0 Act of 2022 (collectively, SECURE) enacted a new mandate that, starting in 2024, long-term, part-time (LTPT) employees must be allowed to make salary deferrals into their employer’s 401(k) plan.
The systems used by many 401(k) plan service providers are not ready for the required implementation starting with the first plan year beginning on or after January 1, 2024 (i.e., January 1, 2024, for calendar year plans).
Some executives may view this change as an issue that does not require their attention, and that will be handled by their human resources (HR) staff and the 401(k) plan service providers. But not complying with the rules might be costly for the employer if corrective contributions for LTPT employees who were not allowed to participate are required, along with ancillary costs.
New Mandate
For decades, tax-qualified retirement plans could exclude employees who work fewer than 1,000 hours of service per year, even if the employee worked for the employer for many years. Employees who worked over 1,000 hours generally could not be excluded from the plan (with certain non-hours-based exceptions). To improve access to workplace retirement savings plans, the 2019 SECURE Act required 401(k) plans to allow employees who have worked at least 500 hours in three consecutive years (based on employment with the employer from January 1, 2021, onward) to make elective deferrals to the plan. Thus, if an employee had 500 hours of service in 2021, 2022, and 2023 (but never had 1,000 hours of service per year), that employee must be allowed to make salary deferrals into the employer’s 401(k) plans starting with the first plan year beginning on or after January 1, 2024. For plan years beginning in 2025 and later, SECURE 2.0 of 2022 reduces the three-year measurement period to two years.
On November 27, 2023, the IRS issued proposed regulations that employers can rely on to apply the LTPT employee rules until the final rules are issued.
An Example of How the Rules Work
Let’s assume a calendar year 401(k) plan has a requirement that employees must be age 21 and complete 1,000 of service before being eligible for plan participation that, includes making elective deferrals and receiving company matching contributions.
Starting in 2024, some employees who do not meet the 1,000-hour service requirement might be eligible to make salary deferrals. The employer is not required to make matching contributions or any other employer contributions for LTPT employees who make salary deferrals.
Counting the hours worked to determine plan eligibility is not new, and the rules are essentially the same for counting 1,000 hours and 500 hours. Hours for new employees should be counted for 12 months following their date of hire, but the measurement period can be switched to the plan year for administrative ease. However, while the 1,000-hour requirement is a standalone measure for each year, the 500-hour count is relevant for two or three years, depending on the plan year under evaluation. Therefore, for a calendar year plan beginning January 1, 2024, the hours are counted for 2021, 2022, and 2023. Any employee whose count is 500 or more but less than 1,000 in each of those three years should be allowed to make elective deferrals into the calendar year plan as of January 1, 2024.
As a further example, assume Susan was hired on June 1, 2021, by an employer that sponsors a calendar year 401(k) plan. On December 31, 2021, the first plan year end after Susan’s hire date, the employer switches her hours worked to be measured based on the plan year. Year One for Susan runs from June 1, 2021, through May 31, 2022. Year Two for Susan runs from January 1, 2022, through December 31, 2022, and Year Three for Susan runs from January 1, 2023, through December 31, 2023. Susan worked 500 hours in Year One, 680 hours in Year Two, and 520 hours in Year Three.
Therefore, effective January 1, 2024, she should be allowed to make elective deferrals under the plan. Note that the switch from counting hours based on Susan’s date of hire anniversary to using the plan year as her eligibility computation period causes the hours she worked from January 1, 2022, through May 31, 2022, to be double counted in both her first and second year.
Even though vesting schedules have no relevance to Susan’s elective deferrals (since she is always 100% vested in her own contributions), she will receive a year of vesting credit for each year after 2021 that she works at least 500 hours (i.e., Susan has three years vesting credit if she became eligible for employer contributions in 2024). This would be significant if she subsequently becomes eligible to participate in the plan for a reason that is not solely on account of being an LTPT employee. Once an individual is eligible for the plan, they remain eligible and do not have to requalify to participate.
For the 2025 plan year, the period from June 1, 2022, through May 31, 2022, will drop out of the determination. Additionally, the period from January 1, 2022, through December 31, 2022, will drop out of the determination because of the change made by SECURE 2.0 to look back only two years instead of three. Accordingly, Susan’s 2025 plan eligibility as an LTPT employee will be based on her hours worked during the 2023 and 2024 plan years.
The future years’ determination is complicated, especially if the employee’s hours worked fluctuate above and below 1,000 hours.
Why Should I be Concerned?
While employers are not required to match the LTPT employee deferrals and LTPT employees are excluded from the annual tests that otherwise apply to all employees (e.g., coverage, nondiscrimination, and top-heavy requirements), there might be some increased cost to the plan sponsor for including LTPT employees in the 401(k) plan. Employers should consider the following potential increases in plan cost due to the new LTPT employee mandate.
- Increased Plan Audit Expense -The additional participants due to LTPT employee status must be counted when determining if the 401(k) plan must have an annual independent audit of the plan’s financials. Starting with the 2023 plan year, 401(k) plans that have more than 100 participant accounts as of the first day of the 2023 plan year must have an annual independent audit. Before 2023, 401(k) plan participants who were eligible to make salary deferrals were counted as participants -- even if they did not contribute anything -- for purposes of counting the number of participants. The DOL changed the rules starting in 2023, among other things, to include only those with account balances as participants. Keep in mind that the number of participants can be decreased by taking advantage of rules that allow distributions of small account balances (accounts valued at less than $7,000 starting in 2024) to former participants.
- Increased Plan Administration Costs – The time spent internally and by plan service providers increases as the number of plan participants increases, particularly if recordkeeping for a new category of participants is necessary. The LTPT employee rules raise unique recordkeeping challenges necessitating new programing and new procedures to stay in compliance.
- Costly Corrective Actions – The employer must take steps to correct any instance of when an employee that is eligible to make elective deferrals was not notified of being eligible. Increasing the number of eligible employees increases the possibility of someone being missed. But the immediate concern is based on feedback that many administration systems are not ready for the implementation of the LTPT rules as early as January 1, 2024 (for calendar year plans). Any delay in communicating the eligibility to LTPT employees that causes a delay of payroll deductions of elective deferrals beyond their eligibility date would be an operational failure that would need correction under the IRS’s Employee Plans Compliance Resolution System (EPCRS). While corrective contributions to make up the employee’s missed contribution are not always required, notices would need to be provided to any participant that had a missed deferral period to advise them that their future retirement savings might need adjustment due to the delay in making elective deferrals.
- Decreased Forfeitures – LTPT employees earn vesting credit for each year after 2021, during which they work at least 500 hours but less than 1,000 hours. While the vested percentage has no impact on the years, the employer does not make contributions on the employee’s behalf; vesting as an LTPT employee carries over to any years that the employee becomes eligible for employer contributions.
- Operational Compliance Before Plan Amendment Deadline - For a 401(k) plan to be “qualified” (that is, eligible for favorable tax treatment), it must comply with the statutory requirements in both form and in operation. SECURE provides that the written plan document is not required to be amended until the end of the 2025 plan year. However, the plan must operate in compliance with the applicable changes in the law for all plan years, starting with the effective date of the change. Since the LTPT rules took effect for plan years beginning on or after January 1, 2024, the 401(k) plan would need to be operated with those rules starting in 2024, even though a formal, written plan amendment is not required until the end of the 2025 plan year. Therefore, any decisions regarding compliance with the LTPT employee provisions should be documented and the proper procedures and controls put in place.
While plan sponsors might rely on their 401(k) plan service providers to identify eligible LTPT employees, liability for noncompliance remains on the employer. The risk associated with not allowing LTPT employees to make elective deferrals to a 401(k) plan can be avoided if the plan lowers the 1,000-hour requirement to not more than 500 hours or determines eligibility on the elapsed time method instead of the counting hours method of determining eligibility to make salary deferrals under the plan.
SECURE provides numerous exceptions from coverage, nondiscrimination, and top heaviness tests for employees who participate in the plan solely on account of the LTPT employee provisions. Any employee that satisfies the more generous plan document provisions will not qualify for the confusing rules that otherwise apply to LTPT employees. Still, avoiding LTPT employee status altogether might be cost effective.
For more information on the above article or any business advisory services, contact Marty Williams, CPA, at (334) 887-7022 or by leaving us a message below.
Written by Joan Vines and Norma Sharara. Copyright © 2024 BDO USA, P.C. All rights reserved. www.bdo.com
