401(k) Coverage and Eligibility

401(k) Coverage and Eligibility Basics

As long as a 401(k) plan meets the coverage requirements of the Internal Revenue Code, not all employees need to be covered. However, an employer should be careful when limiting coverage for many reasons; in particular, a change in the composition of the groups which are covered can result in a failure to meet coverage requirements and lead to disqualification of the plan by the Internal Revenue Service. In addition, the effect the exclusion of certain employees has on their morale must be carefully weighed against the cost savings.

In certain instances, excluding entire categories of employees (e.g., hourly employees) from coverage may be possible. It some cases, it may simplify 401(k) plan administration. For example, the owners of a small company are often the only "highly compensated employees." If the owners do not need to be included in the plan, the exclusion of all highly-compensated employees would eliminate costly nondiscrimination testing.

In addition to excluding particular categories of employees, entire divisions of a company may also be excluded as long as the coverage requirements are satisfied. Also, an employer may test coverage separately for a "separate line of business" that is qualified under certain regulations promulgated by the Internal Revenue Service.

All covered employees must satisfy the plan's eligibility requirements before becoming participants. The law generally permits establishing a maximum entry age of 21 and a service limitation of one year.

When considering eligibility requirements, the employer should note that, although delaying participation may reduce costs, it will make the 401(k) plan less attractive to prospective employees. Also, recent favorable changes in the law may encourage more employers to select immediate eligibility. Frequently, there are dual eligibility requirements for the plan. Allowing employees who are present on the day the 401(k) plan is adopted to be immediately eligible and requiring a waiting period for employees hired after that date is not uncommon. Dual eligibility requirements are also available for employee and employer contributions.

If the company does not wish to cover part-time or temporary employees, a one year waiting period with completion of 1000 "hours of service" can be chosen. If the eligibility period is less than one year there can be no hours of service requirement.Before delaying entry into the 401(k) plan to exclude part-time or temporary employees, the company should analyze the cost savings generated by doing so. It may be very small in light of the relatively small compensation of these employees, their expected rate of participation in the plan and the forfeitures that may occur on any employer contributions made for them. However, the plan may not pass the nondiscrimination tests if the inclusion of these employees lowers the average contribution rate of the non-highly compensated participants. In addition, if the plan is "top-heavy", an employer contribution of up to 3% of compensation may be required for some or all of these employees.

Entry into the 401(k) plan by any particular employee can be permitted on any date after the entry requirements have been satisfied (within certain time restrictions). Allowing immediate entry as soon as the employee has satisfied the eligibility requirements makes it possible for entry to occur on any day during the year. Due to the administrative difficulties this would cause, entry is usually limited to once a month or less frequently.

It is very important to make sure all eligible employees. and only those eligible, are included as participants. Where poor records are kept or employees are dispersed over many offices, mistakes can easily occur that can cause the inclusion of an ineligible (or the exclusion of an eligible) employee. This can subject the plan to unnecessary risks of disqualification of the plan by the Internal Revenue Service.

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