New IRS Guidance on Long-Term, Part-Time Employee Retirement Plan Participation
New proposed regulations clarify how employers should implement retirement plan eligibility rules for long-term, part-time ("LTPT") employees. While some questions remain, the proposed regulations provide a number of welcome answers, which are summarized in this advisory. Armed with this new guidance, sponsors of 401(k) and 403(b) plans should review their documents to assess compliance with the LTPT rules.
Background
Historically, 401(k) plans could exclude from participation any employees who failed to achieve 1,000 hours of service in a 12-month period. In 2019, the SECURE Act altered that long-standing rule and mandated that 401(k) plans permit employees who completed at least 500 hours of service in each of three consecutive years to make elective deferral contributions. In 2022, Congress passed SECURE 2.0 and changed the rule to cover employees who achieve 500 hours in two consecutive years, rather than three, and also clarified that the LTPT rule applied to 403(b) plans.
The three-year rule under the SECURE Act applies with respect to plan years beginning on or after January 1, 2021, while the two-year rule under SECURE 2.0 applies to plan years beginning on or after January 1, 2023. This means the first year that an LTPT employee could commence participation under the three-year rule would be 2024, whereas the first year of participation under the two-year rule would be 2025.
So What's New?
Non-Age or Service-Based Employee Category Exclusions Still Allowed. A frequent question concerning the LTPT law change was whether a plan could continue to exclude employees by virtue of criteria unrelated to age or service. For example, if Company A's 401(k) plan historically excluded its warehouse employees from participating, but some of the warehouse employees met the LTPT requirements, must the warehouse employees be permitted to participate in the future as LTPT employees? The answer is no. Plans may exclude designated categories of employees provided the designated category is not a disguised attempt to exclude employees based on age or service. For example, if an employer assigned all employees to different distinct categories labeled Level A through Level K, an employer could not then avoid the LTPT rules by assigning all part-time employees to Level K and having the plan exclude Level K employees.
Safe Harbor Contributions Need Not Be Provided to LTPT Employees. The LTPT provisions added to the Internal Revenue Code ("Code") were clear that an LTPT employee's participation was limited to elective deferrals, and the employer need not provide employer contributions. Nevertheless, one frequently asked question was whether this exclusion covered employer contributions in a safe harbor 401(k) plan. Fortunately, the proposed regulations make this very clear—if an employer sponsors a safe harbor plan, LTPT participants need not receive any safe harbor employer contributions, and the exclusion will not cause the plan to fail safe-harbor requirements.
Top-Heavy Testing Implications. One advantages of a safe harbor 401(k) plan is that the plan effectively avoids annual top-heavy testing and potential minimum contributions. This exclusion from the top-heavy rules continues to apply even if the safe harbor plan does not provide a safe harbor contribution to LTPT participants. In addition, with respect to 401(k) plans that are not safe harbor plans, an employer can elect whether to provide LTPT participants with a top-heavy minimum contribution (the election must apply uniformly to all LTPT participants). For plans subject to annual top-heavy testing, the account balances of LTPT participants are included in determining whether the plan is in fact top heavy; the ability to exclude LTPT participants from receiving a minimum top-heavy contribution does not alter the requirement to include their account balances in determining top-heavy status.
Discrimination and Coverage Testing Implications. Similar to the top-heavy rules, the proposed regulations permit an employer to elect whether or not to include LTPT participants in discrimination and coverage testing. The election to include or exclude must apply to all non-discrimination and coverage testing purposes. For example, in some situations counting LTPT participants' elective deferral might help a 401(k) plan satisfy the ADP test (i.e., the discrimination test applicable to employee elective contributions). However, if an employer elects to include LTPT participants for that purpose, it must also include the LTPT participants for all other discrimination and coverage testing purposes, such as whether the employer's discretionary profit sharing contribution satisfies discrimination testing under Code Section 401(a)(4).
Even if a plan excludes LTPT participants fordiscrimination and coverage purposes, the plan may nevertheless provide employer contribution for LTPT participants. The regulations provide an example under a plan providing non-LTPT eligible employees with a safe harbor non-elective contribution equal to 3% of compensation, while the LTPT participants receive a non-elective contribution of 2% of compensation. (Remember, LTPT participants need not receive any employer contributions, but an employer could opt to be more generous.) Although LTPT participants are receiving an employer contribution, that contribution is not considered when the plan runs its non-discrimination testing for the year if an election has been made to exclude LTPT participants from the discrimination and coverage analysis.
Note, if an employee is excluded because of a non-age or service-based exclusion (such as our warehouse employee example), but absent the exclusion they would be a LTPT employee, that employee must be included in nondiscrimination, coverage and top-heavy testing.
Limits on Scope of LTPT Characterization. The proposed regulations clarify that an employee is treated as an LTPT participant only if the reason the employee is eligible to participate in the plan is solely by virtue of the LTPT rules. Employees who gain plan eligibility for any other reason are not considered LTPT participants. For example, a plan that permitted all employees to immediately participate in elective employee contributions would never have any LTPT participants, since all employees would always be eligible sooner than satisfying the LTPT eligibility rules. (Note, however, as mentioned above, a plan allowing immediate participation could still exclude a class of employees—such as our example of the warehouse employees—even if some of those employees satisfied the eligibility requirements for LTPT participation). Similarly, a plan that uses elapsed time for eligibility (e.g., plan entry after 6 or 12 months of service without regard to hours of service) will not be subject to the LTPT rules.
In addition, the regulations clarify that once a participant has become eligible for reasons other than the LTPT rules, that employee's status as an LTPT employee need never be revisited. For example, if a plan requires 1,000 hours in the first year of employment to become eligible, and an employee meets that requirement, they are eligible to participate in the plan, and if in later years they work between 500 and 999 hours in two consecutive years, they would not be considered an LTPT participant. This is relevant because for vesting purposes LTPT employees are deemed to have a year of vesting credit upon working at least 500 hours, even if the plan normally requires more hours (such as 1,000) to achieve a year of service for vesting purposes. In this way, it might be advantageous for some employees to shift status to LTPT participants.
There are two noteworthy variations on this concept. First, assume the reverse scenario, where an employee satisfies the LTPT rules (i.e., works 500 or more hours in two consecutive years) and enters the plan as an LTPT participant and makes elective contributions. If in a later year that employee works more than 1,000 hours in a year and thus becomes eligible under the plan's normal eligibility rules, the individual qualifies as a regular participant and is no longer treated as an LTPT participant, except for vesting. (The regulation refers to this type of individual as a "former" LTPT employee or participant.) Since the normal LTPT rules cease to apply, the individual must be included in all non-discrimination and coverage testing and must also receive any applicable top-heavy minimum contribution. Nevertheless, the former LTPT participant remains entitled to vesting for years in which they work 500 or more hours, and so in this limited regard the LTPT rules continue to apply.
The second noteworthy variation addresses the scenario where an LTPT participant shifts employment and becomes ineligible by virtue of falling into an ineligible class of employee (again, our prior example of the warehouse workers). Although the individual would cease to be eligible to make elective employee contributions (i.e., they now belong to an ineligible category of employees), they would remain a former LTPT employee and continue to earn vesting credit for years in which they worked at least 500 hours.
What about 403(b) Plans? The proposed regulations only addressed the LTPT rules with respect to 401(k), and did not address 403(b) plans. It seems reasonable to assume that the 403(b) rules will be substantially identical to the 401(k) rules except where the law provides otherwise. For example, the LTPT rules only apply to ERISA-covered 403(b) plans. This means that governmental and non-elective church plans are exempt from the LTPT rules, as are 403(b) plans that only permit employee elective deferrals and have limited employer involvement and, therefore, are not covered by ERISA. It is unfortunate that the proposed regulations do not address the interplay of the LTPT rules and the permitted exclusion from 403(b) plans for employees who normally work less than 20 hours per week (in practical terms, that exclusion seems inapplicable after January 1, 2025).
+++
No doubt additional questions will arise as employers and plan administrators wrestle with how to apply the LTPT rules in real-life situations. More guidance is likely coming, but for now, plan sponsors can rely on the new proposed regulations, with plan amendments not required until the end of the 2025 plan year.
Please contact your DWT benefits attorney for more information.