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Earlier 401k Plan Eligibility for Employee Contributions Made Easier Next Year

By May 17, 2023No Comments

Given the advantages of offering a 401k Plan to employees as early as possible, recently passed legislation may be a gamechanger for small businesses that want to allow new hires to make their own contributions without immediately incurring the financial burden of making employer contributions.

The plan design for 401k Plans – who is eligible, when are they eligible, what are the available employee and employer contributions and under what conditions – differ based on the employer’s objectives and the demographics of the business’ workforce.  For many small businesses, one impediment to early entry into the Plan for new hires is the cost of employer contributions.

Frequently, small businesses have a 401k Plan that provides for an employer “safe harbor contribution” which is either (1) a matching contribution, which matches what the employee contributes and caps at a maximum match of 4% of pay, or (2) an employer automatic contribution that is a fixed 3% of pay, whether or not the employee contributes and without regard to how much the employee contributes.  The safe harbor feature allows owners and certain family members plus other “highly paid” employees to make employee 401k deferrals from pay at whatever rate they desire, without regard to the employee contribution rates by others.

One of the numerous IRS tests applicable to 401k Plans is a “top-heavy” test.  A Plan is top-heavy if the total account balances for “key employees” – most owners and certain family members plus certain highly paid officers – is at least 60% of the total for the entire Plan.  In a small business Plan, being top-heavy is not uncommon.  In those cases, generally, the employer typically has to make an employer top-heavy contribution of 3% of each eligible participant’s pay.

However, if the Plan design limits employer contributions to the safe harbor contribution, and the eligibility waiting period for employee and employer contributions is the same, there is a “free pass” for the top-heavy test.  To qualify for the top-heavy free-pass and minimize the cost of employer contributions, many small businesses use a waiting period – often the maximum IRS-permitted waiting period of one year of service – for eligibility to make employee contributions and receive employer (safe harbor) contributions.

The year-end legislation that was passed to fund the Federal government through September 2023 included almost 100 provisions changing Retirement Plan and IRA rules or requiring IRS or U.S Department of Labor regulatory action or studies regarding Retirement Plan-related issues.  This part of the law is referred to as SECURE 2.0 because it enhances changes made by the original SECURE Act passed in December 2019.  One of the objectives of SECURE 2.0 was to increase access by employees to 401k and other Retirement Plans.

Effective for plan years beginning in 2024, a 401k Plan that allows immediate or early eligibility for employee 401k deferrals but has a one year of service eligibility waiting period for safe harbor contributions, is allowed to take advantage of the free pass for top heavy testing for the part of the Plan that requires the one year waiting period.  Only those covered by the immediate or early entry for employee deferrals are subject to the top-heavy test – and in most cases, there will not be any key employees in that group.

As such, it now is easier to uncouple the eligibility for employee contributions and allow immediate deferrals, while continuing to use the one year waiting period for employer safe harbor contributions.  Given the advantages of offering a 401k Plan to employees as early as possible, this may be a gamechanger for small businesses that want to allow new hires to make their own contributions without immediately incurring the financial burden of making employer contributions.

ACSI is available to help our clients learn more about the SECURE 2.0 changes impacting your Retirement Plan.

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