Coming Soon: Changes to the 401(k) Plan Participation Rules

Years ago, employers could exclude part-time employees — those who work less than 1,000 hours per year in the business — from participating in 401(k) plans. That was before the Setting Every Community Up for Retirement Enhancement (SECURE) Act became law in 2019. The old rules made life simpler for small employers that preferred to avoid the complications that can arise from allowing part-time workers to participate in retirement plans. Here's how the rules have changed under the SECURE Act and its sequel, SECURE 2.0, which was signed into law in late 2022.

Change for Long-Term Part-Timers

The SECURE Act requires 401(k) plans to allow some part-time employees to make salary-reduction contributions that reduce an employee's taxable salary. These contributions — technically known as "elective deferrals" — reduce an employee's taxable income for the year.

Thanks to the SECURE Act change, salary-reduction contributions must now be allowed for an employee who meets the following two conditions:

• The employee has worked at least 500 hours per year with the employer for at least three consecutive years, and
• He or she is 21 or older by the end of the three-consecutive-year period.

Employees who pass these tests are now classified as "long-term part-time" employees, a new term under the tax code. Note that in determining whether an employee passes the three-consecutive-year test, 12-month periods beginning before January 1, 2021, aren't counted. So, the SECURE Act change won't be mandatory for an employee until January 1, 2024, because no employee can pass the three-consecutive-year test before then.  

The SECURE Act doesn't eliminate the prior-law 1,000-hour-per-year rule. Basically, 401(k) plans must now have a dual eligibility requirement. An employee can become eligible to make salary-reduction contributions by working either:

• At least 1,000 hours in one year, as under prior law, or
• At least 500 hours per year for three consecutive years and being age 21 or older at the end of the three-year period.

In other words, the SECURE Act change only affects employees who work between 500 and 999 hours per year. Those who work fewer than 500 hours can still be excluded from a 401(k) plan as under prior law. Those who work 1,000 hours or more were already eligible to participate in making salary-reduction contributions under prior law.

Important: The SECURE Act change doesn't require long-term part-time employees to be made eligible to participate in other features of a 401(k) plan. So, for example, as under prior law, the plan can continue to treat an employee as ineligible for employer matching contributions if the employee hasn't worked for at least 1,000 hours in a year (that is, hasn't completed a so-called year of service).

Another Change Affecting Part-Time Employees

A change included in SECURE 2.0 further liberalized the 401(k) plan participation rules. It does so by making it easier to be classified as a long-term part-time employee.

Specifically, SECURE 2.0 will reduce the three-consecutive-year rule set forth in the original SECURE Act to two years. The change is effective for plan years beginning in 2025 and beyond.

Moving Target

The 401(k) plan participation rules for part-time employees have become a moving target under the original SECURE Act and SECURE 2.0. Contact your retirement plan advisor if you have questions or want to make sure that your organization's plan documents are up to date and in compliance with the current rules.