New LTPTE Proposed Regs Drop as Effective Date Looms

On Nov. 24, 2023—yes, the day after Thanksgiving!—the Department of Treasury and Internal Revenue Service released a proposed regulation (Prop. Reg.) providing much-anticipated guidance on the “long-term part-time employee” (LTPTE) rules that were first added to the tax code in 2019. These rules become effective for most 401(k) plans on Jan. 1, 2024—a mere 25 working days after the proposed regulations were issued. These proposed regulations may have a significant impact on design decisions and plan administration for many plan sponsors, so immediate action may be needed. This article highlights some of the key issues raised by the Prop. Reg. 

Executive Summary

The Prop. Reg. outlines special rules for individuals participating as LTPTEs, which affect coverage tests, nondiscrimination tests, top-heavy contributions, and vesting computations.  The Prop. Reg. provides the following notable items of guidance:

• An employee is an LTPTE only if the employee becomes eligible under a plan provision that matches the statutory LTPTE service requirement. Designing a plan to be more liberal in order to facilitate compliance with the LTPTE requirement means none of the special rules applicable to LTPTEs apply.
• An LTPTE will earn vesting service for years in which the employee performs 500 hours of service even if the employee doesn't receive employer contributions before earning 1,000 hours of service.
• An LTPTE who earns 1,000 hours of service (or is otherwise eligible for reasons other than as an LTPTE) will continue to accrue vesting service using the 500-hour per year rule. 
• Job class exclusions remain permissible, provided they do not act as proxies for impermissible age or service requirements.
• Confirmation that the 12-month periods that are counted for LTPTE service begin on the hire date and may shift to the plan year. 

The Prop. Reg. also clarifies that plan amendments to reflect eligibility changes (including discretionary changes to broaden eligibility beyond LTPTEs) do not need to be made until the last day of the 2025 plan year for non-governmental plans (2027 for governmental plan). 

The Prop. Reg. is set to apply to plan years beginning on or after Jan. 1, 2024, and employers may rely on them until other guidance is issued.

Background

The SECURE Act of 2019 (“SECURE 1.0”) made a dramatic change to the eligibility requirements for 401(k) plans. 401(k) plans historically have been allowed to require employees to perform 1,000 hours of service in a 12-month period (a “year of service”) before being eligible to participate in the plan. After the passage of SECURE 1.0, with certain exceptions, 401(k) plans no longer can have a service condition that prevents employees from making 401(k) salary deferrals if they have worked at least 500 hours for an employer for 3 consecutive years. [1]

Ex: ABC hired a part-time employee on Jan. 1, 2021 who works 700 hours per year. Assuming this employee meets all other eligibility conditions, such as the plan’s age requirement, he or she will be eligible to make 401(k) deferrals beginning on Jan. 1, 2024 (assuming ABC’s plan is using a calendar year plan year) and assuming this is the entry date for an employee who satisfies the eligibility conditions as of the last day of a plan year.

The SECURE 2.0 Act of 2022 (SECURE 2.0), amended this service requirement, beginning in 2025, to cover employees who have worked at least 500 hours for an employer for two (instead of three) consecutive years. In addition, SECURE 2.0 added parallel provisions to ERISA in order to have similar rules apply to ERISA-covered 403(b) plans (generally beginning in 2025).[2] 

The law provides for numerous special rules that a plan may, or in some cases, must, apply to employees who participate in a 401(k) plan solely due to the LTPTE rules. LTPTEs who are covered by these special rules:  

• May be disregarded for determining whether a plan satisfies the 410(b) coverage test;
• May be disregarded for purposes of compliance with average deferral percentage (ADP) and average contribution percentage (ACP) tests, including for purposes of being entitled to receive ADP test safe harbor contributions;
• Are not required to receive any minimum top-heavy contributions (although they are included when calculating the top-heavy ratio) but are not subject to any special rules regarding the application of the top-heavy exemption for safe harbor plans (discussed below); and
• Must be credited with a year of vesting service for vesting computation periods during which they are credited with at least 500 hours of service (instead of 1,000 hours). 

 

Soley Means Solely

It’s helpful to understand the drafting approach taken in the Prop. Reg. The special rules dealing with LTPTEs apply only if an employee is in the plan “solely” because of the LTPTE rules. The Prop. Reg. takes a strict interpretation of “solely.” An employee who is eligible to defer under a plan provision that is more liberal than the statutory definition of a LTPTE—such as a plan having immediate eligibility or using the elapsed time method—is NOT a LTPTE. For example, if a plan provides for immediate eligibility, then there are no LTPTEs in the plan, even though some of the employees might have satisfied the definition of a LTPTE in the Code. To identify LTPTEs, the plans must determine whether an individual was first eligible to defer solely because of the completion of 500-hours in three (or two) consecutive years, in which case the person is a LTPTE. If an employee enters the plan for any other reason (e.g., the completion of 1,000 hours of service or due to immediate eligibility), then the employee is not a LTPTE for purposes of these rules, even if the employee subsequently goes to part-time status or meets the statutory definition of a LTPTE after entering the plan.  

This strict definition of who is considered a LTPTE dovetails with all the special rules applicable to LTPTEs. A plan with no LTPTEs is not subject to, and may not use, these special rules. Thus, the usual vesting rule (1,000 hour of service rule) will apply to everyone. However, the normal top-heavy and nondiscrimination testing rules will also apply, which could increase plan costs and therefore is something that plan sponsors must evaluate when making design decisions related to LTPTE rules.

Vesting for Current and Former LTPTEs

One of the most ambiguous provisions of the original provision in SECURE 1.0 relates to vesting service for LTPTEs. The statute provides that an individual participating in the plan solely as an LTPTE will vest in employer contributions for each 12-month period for which the employee has at least 500 hours of service. In addition, the statute indicates such rule will continue to apply even after the employee becomes a full-time employee. It was unclear whether this meant that vesting service under the 500-hour rule was earned only if LTPTEs were provided employer contributions. It also was unclear whether the continuation provision meant that the former LTPTEs continued to vest using the 500-hour rule or just that the employees didn’t lose any years earned under the 500-hour rule upon becoming a full-time employee. 

The Prop. Reg. takes the strictest and most unfortunate interpretation of this provision. The Prop. Reg. says that all LTPTEs will earn vesting service using the 500-hour rule, even if they do not receive any employer contributions as an LTPTE. So, LTPTE employees earn vesting for 500 hours of service in a vesting computation period (instead of 1,000 hours), and this will apply to all current and future employer contributions (even if the employee isn’t eligible for employer contributions until earning a 1,000-hour year of service). Furthermore, if the LTPTE earns 1,000 hours of service (or otherwise begins participating for reasons other than LTPTE status, such as more liberal eligibility requirements), the employee must continue to earn years of vesting service under the 500-hour rule. Essentially, for purposes of counting vesting, service will accrue more rapidly for LTPTEs from initial date of hire and if an individual ever participates as an LTPTE, then the more rapid LTPTE vesting will apply forever. 

This interpretation adds significant administrative complexities to a plan that uses the LTPTE service requirement and inserts significant disparities in how employees are treated based solely on when they first earn a year of service. As a result, we expect that many plan sponsors will seek to ensure this vesting rule does not apply to their plans, primarily by designing eligibility so that the plan does not have any LTPTEs.   

Impact on Safe Harbor Plans 

Safe harbor plans with a service-based eligibility condition have a number of administrative and design issues to consider. If a plan does not have a service condition (or uses a service condition that is already more liberal than the LTPTE rules), then no change is required, and the plan will continue to be administered consistently with past practice. 

If a plan has an hours-based service condition of more than 500 hours, then the plan will need to adjust the eligibility requirements to satisfy the LTPTE rules, and there generally will be a class of employees who are newly eligible based on this adjustment. A key issue for safe harbor plans is whether to make these newly eligible participants eligible for the plan’s safe harbor contribution. If the plan covers LTPTEs (i.e., it only includes LTPTEs using the statutory definition of a LTPTE), then the plan can exclude these newly eligible employees from the safe harbor contribution without impacting the existing rules—i.e., ADP and ACP safe harbor status, as well as the top-heavy exemption (if used by the plan), will be retained. 

If a plan uses more liberal eligibility requirements in order to satisfy the LTPTE rules, then the ADP and ACP test safe harbor status is still retained. If the newly eligible group is not eligible to receive the safe harbor contribution (e.g., if the plan requires one year of service to receive the contribution), then that portion of the plan will be disaggregated and subject to the ADP and/or ACP test (which should nearly always pass because everyone in this group are typically NHCEs). This is no different than the existing rules where a plan does not provide the safe harbor contribution to everyone who is eligible to defer. 

If the plan, however, excludes these newly eligible employees from the safe harbor contribution, then the plan cannot use the top-heavy exemption that applies to safe harbor-only plans. While these newly eligible participants will not be entitled to the top-heavy minimum contribution because of Section 310 of SECURE 2.0, the plan must be tested to determine if it is top-heavy, and, if so, all other non-key participants who are at least age 21 with one year of service would need to receive the top-heavy minimum contribution. 

Thus, an employer of a safe harbor plan that wishes to avoid LTPTE complexities by adopting more liberal eligibility must make the decision whether to include newly eligible employees in the safe harbor contribution or continue to exclude them and accept the potential top-heavy status. Employers might be willing to provide the safe harbor contribution to the newly eligible participants if that population is not significant. Otherwise, the employer might decide to accept the top-heavy requirements and ensure all full-time employees (age 21 and 1 YOS) receive the required top-heavy minimum contribution (which, again, might not be significant if the plan uses a 3% nonelective safe harbor or uses a safe harbor match and has high participation rates).

Regardless of the design decision, the employer needs to consider impacts on the plan’s safe harbor notice. Fortunately, a plan’s safe harbor notice is not required to include the plan’s eligibility conditions for deferrals.[3] Thus, even if a notice was sent to currently eligible employees without an update to reflect LTPTE rules, the notice likely does not need to be corrected for that population. 

However, for the newly eligible population, the employer needs to evaluate its notice to determine the best way to proceed. If the employer provides the safe harbor notice to all employees and simply notes when individuals are eligible to defer and when they are eligible for an employer contribution, then the notice likely would need to be updated to ensure that the newly eligible individuals are accurately informed of their ability to defer to the plan. Further, if the newly eligible employees were not provided any notice, then they must be notified of their ability to enroll in the plan. And, of course, if the employer elects to provide the safe harbor contribution to the newly eligible participants, then this notice must meet the safe harbor content and timing requirements. 

Because they are newly eligible participants, the notice must be provided no more than 90 days before the employee becomes eligible to participate in the plan, and no later than the date the employee becomes eligible.[4] Thus, for a calendar year plan, the notice generally must be provided to newly eligible employees by Jan.1, 2024. If it is not practicable for the notice to be provided on or before the date specified in the plan that an employee becomes eligible, the notice will nonetheless be treated as provided timely if it is provided as soon as practicable after that date and the employee is permitted to elect to defer from all types of compensation that may be deferred under the plan earned beginning on the date the employee becomes eligible.[5] Note that the same timing rules also apply to plans with an automatic contribution arrangement.

Therefore, it is incredibly important for safe harbor plans to make decisions on eligibility as soon as possible and then prepare and distribute updated notices in the next month. 

Class Exclusions Still Permitted

One of the more common questions practitioners have had with respect to the LTPTE rules is whether a plan can still apply a job class exclusion to LTPTEs. The Prop. Reg. is clear that job class exclusions are still permitted, provided the class is not a proxy for imposing an impermissible age or service requirement. The proxy prohibition is not new—the IRS has always taken the position that a class exclusion cannot be a way to circumvent the statutory minimum age and service requirements. Thus, a plan could cover only employees in City X and exclude those in City Y, even though some of the employees in City Y meet the service requirements of LTPTEs. 

Unfortunately, these regulations do not address the application of the rules to 403(b) plans so we still do not know if student employees may be excluded even if they satisfy the service requirements of a LTPTE. 

Plan Amendments

The preamble to the Prop. Reg. clarified that plan amendments to reflect the changes in the eligibility requirements to comply with SECURE 1.0 and SECURE 2.0—including discretionary changes, such as providing for immediate eligibility for all employees—do not need to be made until the plan must be updated for other changes for these laws. For non-governmental plans, that would be the last day of the 2025 plan year. Keep in mind, however, that communication to affected employees is still required in order for them to be able to exercise their rights under the plan. 

Determination of 12-Month Periods

The definition of a LTPTE is based on consecutive 12-month periods during which at least 500 hours are completed. The Prop. Reg. reflects the statute – consecutive 12-month periods begin on an employee’s date of hire, but thereafter a plan can either continue to use anniversaries of the date of hire or switch to a plan year computation period. While a detailed explanation of these rules is beyond the scope of this article, one must keep in mind that switching to plan year computation periods means there will be an overlap for the first year where an employee receives double credit for hours worked during the overlap period. 

Ex: Assume a calendar year plan switches to a plan year computation period. An employee is hired on Nov. 2, 2021, the first computation period ends on Nov. 1, 2022. The second computation period would begin Jan. 1, 2022, and end on Dec. 31, 2022. Thus, the hours completed from Jan. 1, 2022, through Nov. 1, 2022, are taken into account for 2 different computation periods. This could result in the employee being credited with two-consecutive 12-month periods of more than 500 hours even though the employee was only employed for 13 months. 

The Prop. Reg. does not address whether a plan can have different eligibility computation periods for different purposes. It is common for plans to switch to the plan year for determining whether employees meet the one year of service requirement for full-time employees. However, a plan might not want to switch to the plan year computation period when determining whether an employee is a LTPTE, especially if the plan year is not a calendar year (see the example below). We hope this issue is addressed when the Prop. Reg. is finalized. 

Ex: A plan uses a Feb. 1 – Jan. 31 plan year. Employee A is hired on Jan. 2, 2021, and works 600 hours per year. Employee A’s initial eligibility computation period is Jan. 2, 2021, to Jan. 1, 2022. If the plan switches to a plan year computation period, then the second computation period is Feb. 1, 2021, to Jan. 31, 2022, and the third computation period is Feb. 1, 2022, to Jan. 31, 2023. Thus, the employee meets the definition of a LTPTE on Jan. 31, 2023, and if the employee must be eligible to defer on Feb. 1, 2023 (the maximum entry date under the law is the earlier of 6 months or the first day of the plan year, after satisfaction of the eligibility requirements). This is why the plan would not want to switch to the plan year computation period and it is why we are hopeful that a plan can have more than one eligibility computation period (e.g., using the anniversary year for LTPTE eligibility, but using the plan year switch for any eligibility calculations that use one year of service).

Impact on Form 5500 Audit

The Prop. Reg. does not address any change to the Form 5500 audit threshold. Under recently revised rules, ERISA-covered plans generally must obtain an annual independent audit if the plan has at least 100 account balances on the first day of the plan year. While LTPTEs generally will not have account balances on Jan. 1, 2024 (the first day on which they become eligible), they may elect to participate and be included in the number of account balances for the 2025 plan year, increasing the potential for a plan to be subject to audit. The IRS noted that it received a number of comments suggesting that LTPTE accounts should be excluded from the count. However, which plans are subject to an independent audit is a matter over which the Department of Labor has authority and, as such, the IRS has no authority to make such a change and the Prop. Reg. does not address the issue. 

Effective Date

The regulation is proposed to apply to plan years beginning on or after Jan. 1, 2024. Taxpayers may rely on the Prop. Reg. until other guidance is published. While a good-faith interpretation of the rules is permitted prior to the issuance of final regulations, practitioners will likely recommend that the Prop. Reg. be followed. 

Plan Corrections

It’s almost certain that some plans will inadvertently violate these rules by not permitting affected employees to make salary deferrals by the applicable effective date. We will issue a separate article addressing the plan correction options available to these plans. 

More Information

Look for a webcast in the coming days that will review the details of this guidance, with case studies to illustrate the rules. Also, don’t miss the ASPPA Winter Symposium, which will include a session focusing on plan design in light of these LTPTE rules.

FOOTNOTES

[1] Section 112 of the SECURE 1.0 Act.

[2] Section 125 of the SECURE 2.0 Act

[3] Treas. Reg. §1.401(k)-3(d). 

[4] Treas. Reg. §1.401(k)-3(d)(3)(ii).  

[5] Treas. Reg. §1.401(k)-3(d)(3)(ii).
 
Kelsey Mayo is the American Retirement Association’s Director of Regulatory Affairs. Robert Richter is Retirement Education Counsel at the American Retirement Association.