Key Points
Minimum Participation Requirements
As a general rule, a qualified plan must cover each employee who has:
- reached age 21, and
- completed one year of service (at least 1,000 hours of service during a 12-month period).
This age and service requirement is called the minimum participation standard. An employee must satisfy both requirements to be eligible to participate in the plan.
The minimum age requirement for most qualified plans is age 21. An employer’s plan may provide for a lower age requirement or no age requirement at all. This allows employers to exclude younger employees — who traditionally have a high rate of turnover — thereby reducing plan costs.
Todd Lawrence, age 18, works in the mail room of a large company. He may legally be excluded from his employer’s qualified plan until he reaches age 21. His employer may choose to cover him earlier, but is not required to do so.
There is one exception: a plan maintained for employees of educational institutions may impose a minimum age requirement of 26, provided the employee is 100% vested immediately upon completing one year of service.
In the past, certain qualified plans — including defined benefit and target benefit plans — could exclude employees who were within five years of normal retirement age (typically 65). No qualified plan may now impose a maximum age requirement. All eligible employees must be permitted to participate, regardless of age.
Guthrie Bledsoe owns a clock shop with a qualified profit-sharing plan. The shop hired a new employee who was 67 years old. The new employee cannot be excluded from participating on the basis of age. Although a defined benefit plan cannot exclude an employee for being too old, it can still require up to 10 years of service before benefit payments begin — so an employee who enters the plan at age 60 could be required to work until age 70 before receiving benefits.
Employees must generally satisfy a one-year waiting period before becoming eligible to participate. This is the maximum allowable waiting period; a plan may provide a shorter period or waive it altogether.
A “year of service” means a 12-month period during which the employee works at least 1,000 hours. This requirement allows plans to exclude seasonal and part-time employees, reducing the cost of the plan.
As an alternative, employers may impose up to a two-year waiting period (for plans other than 401(k)). However, if a two-year requirement is used, the employer must immediately vest all contributions 100% upon eligibility. 401(k) plans are limited to a one-year maximum waiting period.
Breaks in Service
Qualified plans may provide special rules for breaks in continuous service. A break in service means a 12-month period during which the employee worked 500 or fewer hours. A break may result from resignation, a reduction from full-time to part-time employment, or other causes.
As a general rule, when an employee incurs a break in service there is no credit toward participation during that period. Plans frequently provide for “leaves of absence” for specific reasons outlined in the plan documents, granted at the employer’s discretion, which do not constitute a break in service.
The law requires employers to grant employees maternity and paternity leave for pregnancy, birth, adoption, or childcare immediately after the birth or adoption of a child. Employers must count up to 501 hours of maternity or paternity leave as work hours — meaning this type of leave will not cause a break in service.
Plan Entry Dates
Once the age and service requirements are met, the employee must be permitted to participate no later than the earlier of:
- the first day of the first plan year beginning after the date on which the employee satisfied the requirements, or
- the date six months after the employee satisfied both requirements.
Because the law requires participation on the earlier of these two dates, qualified plans with a one-year service requirement must have at least two entry dates. For calendar-year plans, the typical dual entry dates are January 1 and July 1.
An employee satisfies the age 21 and one-year service requirements on May 30 of the current year under a calendar-year qualified plan. Since the employee must be covered no later than six months after meeting both requirements, he or she must be enrolled by November 30. If the plan has only one entry date (January 1), it does not comply with the law — January 1 of the following year would be more than six months away.
Dwayne Jones, age 45, started working on January 1 for a company with a qualified plan requiring a one-year waiting period and two entry dates: March 1 and September 1. Jones satisfies the service requirement on January 1 of the following year. Since he must be covered no later than six months after satisfying both requirements (by July 1), and the first available entry date is March 1, Jones must begin participating on March 1 — the earlier of the two qualifying dates.
Leased Employees
An increasing number of employers rely on leased employees — workers who are technically employed by a leasing company but actually perform services for another employer (the “recipient”). An employer maintaining a qualified plan may be required to cover leased employees and treat them as regular employees. This rule is aimed at preventing employers from avoiding coverage requirements by leasing rather than hiring rank-and-file employees.
A worker will be considered a leased employee of the recipient if:
- the worker provides services under an agreement between the recipient and the leasing organization,
- the worker has performed services for the recipient for at least one year on a substantially full-time basis, and
- the worker provides services of the type historically performed by employees.
An optometrist called an employment agency and leased the services of Otto Nelson. Nelson worked full-time for three years providing services of the type historically performed by optometry employees. Since Nelson worked for more than one year on a full-time basis, he must be treated as a regular employee of the optometrist. Assuming he is over age 21, Nelson must be covered by the optometrist’s qualified plan.
Federal law specifically allows two classes of employees to be excluded from plan participation (though employers may choose to include them):
- Union employees covered by a collective bargaining agreement where retirement benefits were the subject of good-faith bargaining, and
- Nonresident aliens who have no U.S.-source income.
Employers may also choose to exclude the following from coverage:
- employees under age 21,
- employees who have worked fewer than 1,000 hours per year (part-time and seasonal workers), and
- employees who have worked fewer than one year.
Coverage Requirements & Nondiscrimination
A plan may cover certain classes or groups of employees and exclude others — for example, covering salaried but not hourly employees, or covering those who make required contributions. However, these limitations cannot result in illegal discrimination in favor of highly compensated employees.
To prevent discrimination against lower-paid employees, the plan must pass one of the following tests:
- the ratio test, or
- the average benefits test.
Once one of these tests is passed, the plan must also satisfy the 50/40 test.
To apply the coverage tests, employees are classified as highly compensated or non-highly compensated. A highly compensated employee (HCE) is one who:
- owns more than 5% of the employer (at any time during the year or the preceding year), or
- received compensation of $160,000 or more from the employer during the preceding year (2026, inflation-adjusted).
Employers may elect to limit the HCE definition to employees who are both above the compensation threshold and in the top 20% of employees by compensation. This allows employers with many highly paid workers — such as professional corporations — to limit the number of HCEs and reduce nondiscrimination testing burdens.
The ratio test requires the plan to benefit a percentage of non-HCEs that is at least 70% of the percentage of HCEs benefiting under the plan.
A company has 60 employees: 10 are HCEs and 50 are non-HCEs. All 10 HCEs participate (100% coverage). To pass the ratio test, at least 35 non-HCEs must be covered: 100% × 70% × 50 = 35.
If only 8 of the 10 HCEs participate (80% coverage), then at least 28 non-HCEs must be covered: 80% × 70% × 50 = 28.
If a plan fails the ratio test, it must satisfy the average benefits test annually. Under this test, the average benefit provided to non-HCEs (expressed as a percentage of compensation) must be at least 70% of the average benefit provided to HCEs (as a percentage of compensation).
A company has 40 employees, 10 of whom are HCEs. The average benefit for the HCE group equals 20% of their compensation. To satisfy the average benefits test, the non-HCE group must have an average benefit equal to at least 14% of their compensation (70% × 20% = 14%).
After passing the ratio or average benefits test, the plan must also satisfy the 50/40 test: at all times, the plan must benefit the lesser of 50 employees or 40% of all eligible employees. For purposes of this test, employees who have not met age and service requirements, union employees, and nonresident aliens may be excluded. This test is applied to each plan separately — employers cannot aggregate plans to meet it.
A company has 40 employees. Ten failed to meet the age and service requirements, leaving 30 eligible employees. To satisfy the 50/40 test, at least 12 employees (40% of 30) must be covered by the plan.
Plan Disqualification
If a plan fails at any time to pass the nondiscrimination tests, it is disqualified and loses its favorable tax treatment. The consequences are severe:
- Participants must report their entire interest in the plan (less their cost basis) as taxable income in the year of disqualification.
- The employer loses the income tax deductions claimed for the year of disqualification.
Because these consequences are so severe, employers will generally do everything possible to maintain a plan’s qualified status once it has been established.