401(k) Plan Design: Eligibility, Contributions, and Testing

A 401(k) plan design is the set of choices a sponsor makes, inside the limits federal law sets, about who participates, how much goes in, how ownership is earned, when money comes out, and how the plan proves it doesn’t favor higher-paid employees. Every plan must be established through a written document that names the people responsible for running it and spells out how it operates day to day.¹ The choices inside that document drive the plan’s cost, its testing obligations, and the benefit employees actually receive.

Who Can Join and When

Eligibility is the first design lever. The most restrictive standard federal law allows is the “21 and 1” rule: an employer can require workers to reach age 21 and complete one year of service, defined as a 12-month period with at least 1,000 hours of work.² Many employers loosen this to attract talent, allowing entry after three or six months.

Once an employee qualifies, the plan document sets the actual entry date. Common choices are the first day of the following month or semi-annual dates such as January 1 and July 1. Participation must begin no later than the earlier of six months after the employee meets the requirements or the first day of the next plan year.²

Long-Term Part-Time Workers

Starting in 2025, part-time employees who put in consistent hours can no longer be excluded. A worker who logs at least 500 hours per year for two consecutive 12-month periods must be allowed to make elective deferrals.³ The sponsor is not required to give these employees matching or profit-sharing contributions, but any year they work at least 500 hours must count toward vesting service. That matters most in retail, hospitality, and other industries where staff often fall between 500 and 999 hours a year.

Automatic Enrollment

Any 401(k) plan established on or after December 29, 2022 must include automatic enrollment.⁴ Eligible employees are enrolled at a default deferral rate between 3% and 10% of pay, with the ability to opt out or pick a different percentage. The plan must automatically increase each participant’s rate by at least one percentage point per year until it reaches at least 10%, capped at 15%.

Plans that existed before December 29, 2022 are exempt from the mandate, as are small businesses with 10 or fewer employees, companies less than three years old, and church and government plans. Older plans still add auto-enrollment voluntarily because it lifts participation and helps with nondiscrimination testing. Sponsors have to give participants clear disclosures explaining the default rate, investment options, and how to change or stop the election.

Employee Contributions and the 2026 Limits

For 2026, an employee can defer up to $24,500 of salary. Participants aged 50 and older can add $8,000 in catch-up deferrals, bringing their personal ceiling to $32,500. A higher catch-up of $11,250 applies to employees aged 60 through 63, a provision added by SECURE 2.0.⁵

Total contributions to a single participant’s account in 2026, employee plus employer, cannot exceed $72,000, or $80,000 and $83,250 with the applicable catch-up included. Only the first $360,000 of an employee’s pay can be used when calculating employer contributions or running the nondiscrimination tests.

Employer Contribution Choices

Employer money into the plan comes in three forms. Matching contributions are tied to what the employee defers, such as 50 cents on the dollar up to 6% of pay. Non-elective contributions go to every eligible participant whether or not they defer. Profit-sharing lets the employer decide each year how much to contribute, usually as a percentage of each participant’s compensation.

The document must define which compensation counts toward these calculations. Most plans use gross W-2 wages, but some exclude bonuses or overtime. The definition cannot discriminate in favor of higher-paid employees, and no matter what definition is used, it is capped at $360,000 per person for 2026.

Safe Harbor Designs

A Safe Harbor plan commits the employer to a specific contribution formula and, in return, automatically satisfies the ADP and ACP nondiscrimination tests. Two formulas qualify:

Basic Safe Harbor match: 100% of employee deferrals up to 3% of pay, plus 50% of deferrals between 3% and 5%, for a maximum employer match of 4% of compensation.⁶
Safe Harbor non-elective: a flat 3% of compensation contributed to every eligible employee, whether they defer or not.⁶

Both formulas require full vesting when the contribution is made. Sponsors can layer a discretionary profit-sharing contribution on top of the Safe Harbor formula, and that piece can follow a regular vesting schedule.

Roth Option

A plan can include a designated Roth contribution option, letting employees direct some or all of their deferrals into a separate Roth account. Roth contributions are included in the employee’s taxable income the year they’re made, but qualified withdrawals, including all earnings, come out tax-free.⁷ A distribution is qualified if it happens after age 59½ (or disability or death) and at least five tax years after the first Roth contribution to the account.⁸ The annual $24,500 limit applies to the pre-tax and Roth totals combined.

Starting in 2026, employees aged 50 and older whose FICA-taxable wages from the plan sponsor were $150,000 or more the prior year must make any catch-up contributions as Roth. If the plan doesn’t offer a Roth option, those higher-paid employees cannot make catch-up contributions at all. That makes a Roth feature close to a necessity for most sponsors going forward.

Vesting Schedules

Vesting sets how quickly participants earn permanent ownership of employer money. Employee deferrals, pre-tax and Roth, are always 100% vested immediately.⁹ For employer contributions other than Safe Harbor amounts, the document must use one of two structures:

Three-year cliff: the participant owns nothing until three years of service, then becomes 100% vested at once.¹⁰
Two-to-six-year graded: ownership rises 20% per year starting after year two, reaching 100% at year six.¹⁰

Sponsors can always vest faster than these minimums, and immediate vesting is increasingly common among employers competing for talent. Unvested amounts left behind by departing employees become forfeitures, which stay in the plan and are typically used to reduce future employer contributions or pay plan expenses.

How the Plan Will Pass Nondiscrimination Testing

To hold its tax-qualified status, a 401(k) has to prove annually that it doesn’t disproportionately favor highly compensated employees. For the 2026 plan year, a highly compensated employee is anyone who owned more than 5% of the business during the current or prior year, or earned more than $160,000 from the employer in 2025.¹¹

ADP and ACP Tests

The Actual Deferral Percentage test compares the average deferral rate of highly compensated employees against the rate for everyone else. The highly compensated average cannot exceed the other group’s average times 1.25, and the gap between the two cannot exceed two percentage points (with the highly compensated average capped at double the other group’s).¹² A parallel Actual Contribution Percentage test applies the same math to employer matching and after-tax employee contributions.

Failing either test means the sponsor has to either distribute excess contributions back to highly compensated employees or make additional contributions for everyone else, with a 10% excise tax if the correction isn’t done within two and a half months after the plan year ends.¹³ This is the exposure Safe Harbor designs eliminate by committing to a specific contribution formula in advance.

Top-Heavy Testing

Top-heavy testing is a separate check using key employees rather than highly compensated employees. Key employees include officers earning more than $235,000 in 2026, owners of more than 5% of the business, and owners of more than 1% earning over $150,000. A plan is top-heavy when key employees’ combined balances make up more than 60% of total plan assets as of the last day of the prior plan year.¹⁴

When a plan crosses that line, the sponsor must contribute at least 3% of compensation for all non-key employees. Plans with Safe Harbor contributions that already meet the 3% floor usually satisfy this without extra cost.

Access to Money: Withdrawals, Loans, and RMDs

The plan document controls when participants can reach their money outside of leaving the company or retiring. Many plans allow in-service distributions once a participant reaches age 59½. Hardship withdrawals are available earlier but only for an immediate and heavy financial need such as unreimbursed medical expenses, preventing an eviction, or paying funeral costs.¹⁵ The document has to spell out which hardship reasons qualify and what documentation participants must provide.

Loans are an optional feature, not a requirement. If the plan allows them, the loan is capped at the lesser of $50,000 or half the participant’s vested balance, with a floor of $10,000. Loans must be repaid within five years through substantially level payments made at least quarterly, with a longer period allowed for a primary-home purchase.¹⁶ The document sets the maximum number of loans a participant can have outstanding at a time, the interest rate methodology, and any fees.

Distributions taken before age 59½ generally trigger a 10% additional tax on top of income tax.¹⁷ The statutory exceptions (separation from service after age 55, death, disability, qualified domestic relations orders, birth or adoption up to $5,000, and federally declared disaster losses up to $22,000) come from the tax code itself, so the plan document doesn’t need to list them. Still, designing generous loan and hardship rules can reduce the number of participants who take penalty-triggering distributions in the first place.

Once a participant reaches age 73, required minimum distributions begin. The first is due by April 1 of the year after reaching that age, and each following distribution by December 31. Participants still working for the sponsor who own 5% or less of the business can delay RMDs until April 1 of the year after they retire, but only if the document includes that still-working exception. Worth putting in explicitly: leaving it out forces active employees to take distributions they may not want.

Fiduciary and Reporting Obligations Built Into the Design

Anyone with decision-making authority over the plan’s management, assets, or administration is a fiduciary, including trustees, administrators, and investment committee members. Fiduciaries must run the plan exclusively for participants’ benefit, act with prudence, diversify investments to minimize the risk of large losses, and follow the plan document to the extent it complies with federal law. Breach exposes the fiduciary personally: they can be required to restore plan losses, surrender profits from misuse of plan assets, and be removed by a court.¹⁸ Department of Labor enforcement often targets fiduciaries who pick high-cost investments without a documented review or fail to monitor service provider fees over time.

Every plan holding assets has to file an annual return.¹⁹ Plans with 100 or more participants file the full Form 5500; smaller plans use Form 5500-SF; one-participant plans use Form 5500-EZ and can skip filing entirely if total plan assets are $250,000 or less. The deadline is the last day of the seventh month after the plan year ends (July 31 for a calendar-year plan), with a two-and-a-half-month extension available to October 15. The document should clearly assign responsibility for preparing and filing this return.

Keeping the Document Current

The plan document isn’t a set-and-forget file. Whenever Congress changes the retirement plan rules, the IRS sets a deadline for adopting conforming amendments, and the obligation continues as long as the plan holds assets.²⁰

For pre-approved plan documents, the type most small and mid-size employers use, interim amendments reflecting new legislation are due by the later of the employer’s tax return deadline or the end of the plan year in which the change takes effect. Discretionary amendments, such as adding a Roth option or changing the match formula, must be adopted by the end of the plan year in which the change becomes effective.²⁰ Retroactive amendments are generally allowed, but operations have to match. Running the plan one way while the document says something different is one of the most common audit findings, and one of the easiest to prevent by scheduling a document review each year alongside compliance testing.

1
Office of the Law Revision Counsel. 29 U.S. Code 1102 – Establishment of Plan
2
Office of the Law Revision Counsel. 26 U.S. Code 410 – Minimum Participation Standards
3
Internal Revenue Service. Notice 2024-73 – Additional Guidance on Long-Term Part-Time Employees
4
Federal Register. Automatic Enrollment Requirements Under Section 414A
5
Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026, IRA Limit Increases to $7,500
6
eCFR. 26 CFR 1.401(k)-3 – Safe Harbor Requirements
7
Internal Revenue Service. Retirement Plans FAQs on Designated Roth Accounts
8
Office of the Law Revision Counsel. 26 U.S. Code 402A – Optional Treatment of Elective Deferrals as Roth Contributions
9
Internal Revenue Service. Retirement Topics – Vesting
10
Office of the Law Revision Counsel. 26 U.S. Code 411 – Minimum Vesting Standards
11
Office of the Law Revision Counsel. 26 U.S. Code 414 – Definitions and Special Rules
12
Office of the Law Revision Counsel. 26 U.S. Code 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans
13
Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
14
Internal Revenue Service. Is My 401(k) Top-Heavy?
15
Internal Revenue Service. Issue Snapshot – Hardship Distributions From 401(k) Plans
16
Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
17
Office of the Law Revision Counsel. 26 U.S. Code 72(t) – 10-Percent Additional Tax on Early Distributions From Qualified Retirement Plans
18
U.S. Department of Labor. Fiduciary Responsibilities
19
Office of the Law Revision Counsel. 29 U.S. Code 1023 – Annual Reports
20
Internal Revenue Service. 401(k) Plan Fix-It Guide – You Haven’t Updated Your Plan Document