January 2024

Q&A: Proposed rule on long‑term part‑time employees’ 401(k) eligibility

A Q&A with Mike Hadley, partner at Davis & Harman LLP

The end of 2023 saw an increase in the release of proposed regulations and other regulatory guidance. Among them was a long-awaited proposed rule from the IRS on a provision of the SECURE Act of 2019, which was further addressed in the SECURE 2.0 Act of 2022, concerning when long-term part-time (LTPT) employees are eligible to make elective deferrals into their employer-sponsored 401(k) plan.

Workplace Insights™ interviewed Mike Hadley, partner at Davis & Harman LLP in Washington, D.C., to gain insights on what plan sponsors should know about the proposed rule.

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Workplace Insights™ (WI): Can you provide a little background on the proposed rule?

Mike Hadley (MH): As part of the first SECURE Act enacted late in 2019, Congress added a provision that required employees referred to as “long-term part-time employees” to be eligible to make elective deferrals into employer-sponsored 401(k) plans after three years of service. Plans needed to start tracking service for this new rule in 2021, so part-time employees can become eligible in 2024. Subsequently, the SECURE 2.0 Act of 2022, enacted on December 29, 2022, included a provision to accelerate that eligibility from three years to two years, effective in 2025.

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WI: Why was the regulation needed, and what does it address?

MH: When Congress makes a change to a law, it is often necessary for a regulatory agency to issue guidance on how the law should be applied and fill in missing details that Congress did not address. This particular change raised a surprising number of interpretive questions—including how to determine this new LTPT status, the impact on vesting and nondiscrimination testing and several other issues.

In November of 2023, the IRS proposed a rule to address these issues. It is open for comment through January 26, 2024, and there is a public hearing scheduled for March of 2024. This will give the public the opportunity to comment on the proposed rule, ask questions about anything that may need to be clarified and provide input to the IRS about potential concerns regarding their interpretation of the rule. Once the public comment period has closed, the IRS will consider the public input, determine if any revisions are needed and then issue a final rule. There is no set timeframe by which the IRS must issue a final regulation. It could be later in 2024, or possibly into 2025.

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WI: Do plan sponsors have to comply with this rule while it is in proposed status, or can they wait until the rule is finalized?

MH: That’s a good question! This new LTPT coverage requirement from the SECURE Act is in effect, so plan sponsors must comply with the coverage requirements even though this regulation is only proposed. Regulations are issued as proposed so that regulators may gather feedback and input from those who have to comply with the rule to help them consider modifications before the rule is finalized. Of course, this proposed regulation provides guidance on some of the details. The IRS has said that until a final rule is issued, plans “may rely” on the guidance in the proposal. Once the IRS finalizes the regulation, they will tell employers when they must follow it exactly.

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WI: You said plan sponsors “may rely” on the guidance in the proposed regulation. But this proposal was issued just a little over a month before employers need to start allowing LTPT employees into the plan. What if plan sponsors need more time to comply? Are they considered acting in good faith as long as they are working as quickly as possible to incorporate the proposed rule guidelines?

MH: I was a bit surprised that the IRS did not explicitly give plan sponsors more time to review this proposal and comply. I expect there will be some comment letters submitted to the IRS requesting that they recognize the rule as complex and that a reasonable, good faith effort to comply should be sufficient.

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WI: Let’s talk about some of the provisions in the proposal and what issues have already been raised. First, can you explain how an LTPT employee is defined and what the proposal includes to help make that determination?

MH: Generally, an LTPT employee is defined as an individual who has three consecutive years of at least 500 hours of service each year for the 2024 plan year, and two consecutive years with at least 500 hours of service for the 2025 plan year and beyond.

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WI: Does this make the LTPT employee eligible for employer-matching or non-elective contributions?

MH: No, this LTPT eligibility solely allows access to make elective deferrals into the plan. Of course, a plan sponsor is not prohibited from offering LTPT employees matching or non-elective contributions.

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WI: What happens if an employee meets the LTPT definition but becomes eligible for the plan under a more generous rule?

MH: The proposed regulation provides a narrow definition of an LTPT employee. An employee will only be treated as LTPT if they are eligible to participate in the plan “solely by reason” of having completed the 500 hours per year for the required number of years (three years in 2024, down to two years beginning in 2025). A key point in the proposal is the clarification that an employee who becomes eligible under another service requirement under the plan, including an employee who becomes eligible under a service requirement that is more advantageous, is not considered an LTPT employee. This is important, because only an employee who is considered an LTPT is eligible for relief from the nondiscrimination, minimum coverage and top-heavy rules.

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WI: Can you talk a bit more about how the 500 hours are calculated?

MH: Under the proposal, for purposes of the eligibility rules for LTPT employees, an employee’s initial 12-month period must begin on the first day for which the employee is entitled to be credited with an hour of service. Subsequent 12-month periods may be determined either by reference to the anniversary of the date of hire, or by reference to the first day of the plan year—beginning with the plan year that commences within the initial 12-month period. Switching to the plan year could result in the same hour of service being credited twice to a participant in two different computation periods. The proposed regulation also clarifies that if a plan has an hour “equivalency rule” (that is, the plan credits a certain number of hours per day if the employee works at least one hour that day), the same “equivalency rule” could be used to determine LTPT status, for administrative convenience.

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WI: How far back does a plan sponsor have to look at employee service to see if they are eligible under the new LTPT provisions of SECURE and SECURE 2.0?

MH: Generally, a plan sponsor can disregard service during 12-month periods beginning before January 1, 2021. The proposed regulation provides that if a plan does take into account periods before January 1, 2021, an employee who enters a plan under that rule is not considered LTPT—thus, the nondiscrimination and similar relief do not apply.

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WI: How does this impact vesting?

MH: Consistent with the statute, the proposed regulation provides that each 12-month period during which an LTPT employee (or former LTPT employee) is credited with at least 500 hours of service is treated as a year of vesting service. This means that even after an employee has a year of service with 1,000 hours, they will continue to earn vesting credit for all years in which they have at least 500 hours of service.

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WI: How is nondiscrimination testing impacted?

MH: An employer may elect to exclude LTPT employees from the nondiscrimination requirements, the ADP test, the ADP test safe harbor, ACP test, ACP test safe harbor and the minimum coverage requirements. Note that this election does not apply to former LTPT employees. Once an employee has a year with 1,000 hours of service, they may not be excluded from the various testing rules.

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WI: What is the impact of LTPT status on the top-heavy rules?

MH: If a plan is top-heavy, the SECURE Act provides that an employer may elect to exclude LTPT employees from the top-heavy rules. For example, an employer does not need to provide an LTPT employee with an employer top-heavy minimum contribution. The proposed regulation clarifies, however, that LTPT employees are not excluded in determining if the plan is top-heavy in the first place.

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WI: What if an LTPT employee has a break in service?

MH: This was one of the bigger surprises to me in the proposal—there are no break-in-service rules. So, if a former employee who was eligible to participate as an LTPT employee is rehired by an employer maintaining the plan, the 12-month periods during which the employee previously was credited with at least 500 hours of service must be taken into account. In other words, it appears that if an employee qualifies as an LTPT employee, quits as an LTPT employee, and returns 20 years later, they must be immediately eligible as an LTPT employee. I am expecting the IRS to receive comments on that.

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WI: Suppose a plan has an “elapsed time” method for tracking eligibility. What is the impact of the rule?

MH: One of the most common questions about the new LTPT employee rule has been how it would impact plans that determine eligibility based on the “elapsed time” method. Under this method, the employer does not track hours but rather focuses on the number of 12-month periods during which an employee is employed. The proposed regulation would not amend the rules for plans that use the “elapsed time” method. So long as a part-time employee becomes eligible under the “elapsed time” method (basically, by being employed for one year), the plan would automatically comply with the LTPT rule. The IRS does say in the proposal, however, that if an employee becomes eligible for the plan under the “elapsed time” method, the employee is not treated as an LTPT employee for purposes of the various nondiscrimination rules.

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WI: What if a plan sponsor already sent out a safe harbor notice?

MH: This would be a good one to discuss with counsel, as it may depend on the situation. The IRS did not address the safe harbor notice. A safe harbor notice may already incorporate the impact, if any, of the new LTPT rules on the plan. Even if it does not, in many cases, the safe harbor notice may not need to change, because most safe harbor notices do not describe a plan’s eligibility requirements. Perhaps the more important point is ensuring that a plan sponsor actually sends a safe harbor notice to LTPT employees who are newly eligible for the plan and communicates whether LTPT employees will be eligible for employer contributions.

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WI: How must a plan sponsor notify LTPT employees that they are eligible to make elective deferrals into the plan?

MH: Plan sponsors must follow the same notification of eligibility guidelines they do whenever an employee is eligible for the plan under existing eligibility guidelines.

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WI: Can a plan sponsor exclude LTPT employees based on another exclusion?

MH: Yes, the proposed regulation confirms that the special rules for LTPT employees do not preclude a plan from establishing an eligibility condition that must be satisfied. For example, if all employees at Location A are excluded from the 401(k) plan, then LTPT employees do not need to be eligible. However, the IRS has emphasized in the proposal that this other eligibility rule cannot be a proxy for a service requirement, such as, requiring that an employee be “classified as full-time.” Also note that, as under prior law, a plan may continue to exclude an employee who has not attained the age of 21. This may be helpful if an employer employs a lot of students.

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WI: Do plans need to be amended to comply with the LTPT rules?

MH: Yes, generally, plan amendments must be made by the end of the 2025 plan year unless the IRS provides a delay.

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WI: Is there anything else plan sponsors should be considering related to this proposed rule?

MH: I would point out that this new rule offers a number of plan design choices, and each one has pros and cons. Simply complying with what the LTPT rule requires is one such design choice, but it requires a careful tracking of hours.

Alternately, a plan sponsor might just decide to make all part-time employees eligible immediately and offer them the same employer contributions. This might be easy to administer, but it could result in nondiscrimination testing issues or many small-balance accounts.

Since this rule has been coming for three years, many plan sponsors have already made decisions about how to deal with it. I would urge plan sponsors to speak with their consultants and counsel to discuss how best to use plan design to accommodate this new focus on coverage for part-time employees.