14 answers you should know about 401(k) eligibility and vesting

Some of the most profound decisions you’ll make about a 401(k) plan are who can participate, when they can start, and when the money you contribute to employee accounts will totally belong to them. Based on a thorough review of ERISA regulations, here’s some bite-sized information to help you understand the basics of plan eligibility and vesting.

Background questions

1 How do you define 401(k) plan eligibility and vesting?

A plan’s eligibility provisions determine when and under what circumstances a new employee can become a plan participant. 

The vesting provisions affect people who already participate in the plan. Assuming the employer contributes to employees’ accounts, the vesting schedule determines when this money will actually belong to the participants and be available for them to withdraw or borrow from.

2 Why are eligibility and vesting so important to plan professionals?

Eligibility and vesting have an impact on how effectively your 401(k) plan works as a recruiting and retention tool, and what effect it has on your benefits budget. Immediate eligibility and vesting can be powerful incentives for potential employees to join your organization. And by setting your vesting requirements strategically, you can help successful performers feel appreciated and secure.

You also need to understand eligibility and vesting because, as a retirement plan fiduciary, you're required to stick to the rules.

Questions about 401(k) eligibility

3 What are the ERISA compliance guidelines for setting 401(k) eligibility?

Under ERISA, a plan sponsor can exclude employees from eligibility until they reach age 21, complete a year of service, or both.  

As for eligibility schedules, there are several from which to choose, and a plan can include different eligibility periods for full- and part-time employees. Examples of eligibility schedules include: 

  • Immediate eligibility (no service requirement)
  • 1 month or 30 days of service
  • 60 days of service
  • 3 months of service
  • 6 months of service
  • 1 year of service 

To help ensure that plans with full-year service requirements get employees enrolled in a timely manner, ERISA requires semi-annual entry dates. The objective is to avoid having any otherwise eligible employee wait longer than 18 months to enroll.

4 Which eligibility service requirements are employers using?

The good news for prospective employees is that the majority of plan sponsors offer immediate or near-term eligibility, with 37.8% of plan sponsors making their 401(k) plan available on day one, while another 29.6% make employees eligible within three months. 

A fairly large percentage of plans do carry a one-year service requirement—largely driven by the type of business they’re in. Many of these plans are offered by organizations with short-term, high-turnover workforces.

Defined contribution plan eligibility among plans of all sizes 

Bar chart illustrating differences in defined contribution eligibility among companies of various sizes. Ranges from immediately upon hire, used by 37.8% of plans, to after one year of employment or higher, used by 1.4%. Sources is the “2021 PLANSPONSOR Defined Contribution Plan Industry Report."

SOURCE: “2021 PLANSPONSOR Defined Contribution Plan Industry Reports,PLANSPONSOR, 2021. Includes 401(k) and other types of defined contribution plans.

5 Once the service requirement has been met, when can employees enter the plan?

There are two ways a plan can determine the enrollment date:

  • With a static date approach, employees can only enter the plan at some preset interval, such as monthly, quarterly, or semiannually.
  • With a rolling date approach, employees can enroll immediately after reaching their required service date or anytime afterward.

6 Can a plan sponsor set varying eligibility requirements for different types of contributions?

Yes. While employees can usually begin contributing money from their paycheck as soon as they become enrolled, plan sponsors can set separate service requirements for employee, employer matching, and profit-sharing contributions. 

The required service period for profit-sharing contributions can be as long as two years—but any benefits awarded after that date must be 100% vested when received by the participant.

7 Can some classes of employees be excluded from a 401(k) plan?

Yes. Among the employee classes that can be excluded under ERISA are:

  • Independent contractors 
  • Leased employees 
  • Union employees (unless the bargaining agreement permits inclusion)
  • Interns
  • Seasonal employees
  • Temporary employees
  • Non-resident aliens

Plan sponsors should tread carefully about excluding employees based on hours “scheduled to work.” Employees who log at least 1,000 hours over a 12-month period—which is a little over 19 hours a week-—must be considered eligible.

After all exclusions are factored in, every 401(k) plan is still required to pass coverage tests under section 410(b) of the Internal Revenue Code. 

8 How does eligibility work for employees who move into an eligible class—or who leave the organization, then return?

Each of these situations has its own corresponding rule.

  • When employees move from an ineligible class to an eligible one, all their previous work time goes toward meeting the plan’s service requirement. 
  • Plan participants who leave your organization and later return must be made immediately eligible. 
  • And as for employees who leave before becoming eligible—and subsequently return—their prior service time must generally be applied toward future eligibility.

It’s important for plan sponsors and recordkeepers to keep close track of pertinent employment histories and eligibility statuses.

Questions about 401(k) vesting

9 Do vesting rules apply to a participant’s entire 401(k) account?

No, just part of it. A 401(k) plan’s vesting provisions determine only how and when a participant gains ownership in contributions that the employer makes. The money a participant contributes—and any growth on those contributions—belongs 100% to that participant, from day one.

That said, plan sponsors can define a set schedule for transferring (or vesting) ownership of the contributions they make themselves to participants’ accounts.

10 Which types of vesting schedules are available—and are there limits on how long they can last?

There are two types of vesting schedules, and each one sets a limit on how long it takes for participants to become fully vested in their employers’ contributions.

  • With cliff vesting, participants flip from 0% vested to 100% vested when the service requirement period is reached. Three years is the maximum cliff vesting period.
  • With graded vesting, the percentage of vested assets increases incrementally over time. A graded schedule must provide for at least 20% vesting within two years and full vesting within six.

11 How are plan sponsors handling vesting today?

Among all types of DC plans, more than twice as many use graded vesting of employer-matching contributions as use cliff vesting.

Type of vesting used by DC plans for employer matching contributions

SOURCE: “2021 PLANSPONSOR Defined Contribution Plan Industry Report,” PLANSPONSOR, 2021. Includes 401(k) and other types of DC plans.

As with eligibility provisions, more than one-third of plans offer participants immediate vesting in their employer match; however, nearly the same percentage use vesting periods of five and more than five years.

 

DC vesting periods for employer-matching contributions

A bar chart comparing vesting periods used by defined contribution plan sponsors. "Immediately upon hire" ranks first at 39.7% , followed by five years at 17.5%, and over five years at 14.9%. Source is the "2021 PLANSPONSOR Defined Contribution Plan Industry Report."

SOURCE: “2021 PLANSPONSOR Defined Contribution Plan Industry Report,” PLANSPONSOR, 2021Includes 401(k) and other types of DC plans.

12 What happens to nonvested employer contributions when participants leave an organization? 

The money must be moved into the plan’s forfeiture or suspense account, where it can be used to:

  • Cover other employer contributions already payable by the plan
  • Restore the accounts of rehired employees, subject to certain criteria 
  • Pay ERISA-approved plan expenses
  • Make additional employer contributions for existing plan participants 

Regardless of which option a plan sponsor uses, ERISA specifies that any forfeited contributions be used for an appropriate purpose by the end of the plan year.

A question about both eligibility and vesting

13 How is service time calculated?

Both 401(k) plan eligibility and the vesting of employer contributions hinge on the achievement of service milestones. ERISA provides two ways to calculate a required year of service.

  • The first is elapsed time—or the actual number of days the employee has been on the job starting from the official date of hire. 
  • The second is the 1,000-hours-of-service-per-year standard. This measure, which is ERISA’s minimum service threshold for 401(k) plan eligibility, calls for counting actual hours worked. It’s worth noting that an employee’s first calculation comes after the first 12 months of service—and that things generally revert to a plan-year count for the rest of that worker’s tenure.  

Finally, the most vital question 

14 Does your plan design work for your employees and your organization?

It can be a challenge to determine the right mix of eligibility and vesting requirements for your organization. Consult with your plan professionals and recordkeeper and ask them to help you model and benchmark different scenarios to design eligibility and vesting in a way that meets your staffing and budget needs—and keeps your 401(k) plan reliably compliant.

THIS IS INTENDED FOR A PLAN SPONSOR AUDIENCE

The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.

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