FIN 422 Week 2 Federal Law and Participation Requirements Example

The Rules a New 401(k) Must Follow: ERISA Duties, Eligibility, Vesting, Nondiscrimination Testing and Automatic Enrollment for Ridgeline Design's First Plan

[Student Name]

University of Phoenix

FIN/422: Retirement and Benefit Planning

Week 2 Assignment

[Instructor Name]

[Date]

Ridgeline Design and its workforce are composites written for a model paper; legal requirements are summarized generally from the sources listed and should be confirmed with plan counsel and current guidance.

Ridgeline Design, the composite Denver firm from Week 1, has chosen to explore a 401(k) with an employer match and profit sharing. Before choosing a recordkeeper, the partners asked their benefits advisor what the law would require of them and what choices it would leave to them. A 401(k) is a set of promises made under federal law, and the partners become responsible for keeping them the day the plan begins. This paper explains the rules and the design choices they shape.

ERISA and the Partners' New Duties

The Employee Retirement Income Security Act of 1974 sets standards for private employer plans: participation, vesting, funding for defined benefit plans, fiduciary conduct and reporting and disclosure. The partners, as the plan sponsor and named fiduciaries, must put participants' interests ahead of their own, act with the care a knowledgeable professional would use, diversify plan investments, follow the plan documents and pay only reasonable fees from plan assets. A fiduciary who breaches those duties can be personally liable to restore losses (U.S. Department of Labor, 2021). Hiring an investment adviser who accepts fiduciary status shares, but does not remove, that responsibility.

Qualification Under the Tax Code

The plan's tax advantages, deductible employer contributions and tax-deferred growth, depend on meeting the Internal Revenue Code's qualification requirements, which overlap with ERISA's participation and vesting rules and add coverage and nondiscrimination tests (Internal Revenue Service, 2025). A plan that fails them and is not corrected can lose its qualified status, making contributions taxable to employees.

Who Can Join

The law lets a plan require employees to reach age 21 and complete one year of service, generally 1,000 hours in a year, before joining. Ridgeline could use those maximums, but doing so would exclude several young designers it wants to keep. The partners chose a shorter rule: employees may defer salary after 60 days and receive the match after six months. Separately, a recent change requires 401(k) plans to let long-term part-time employees, those working at least 500 hours in each of two consecutive years, make deferrals. Ridgeline has two part-time drafters who will qualify under that rule.

When Contributions Belong to Employees

Employee deferrals are always fully vested. Employer matching and profit-sharing contributions may vest over time, but no more slowly than a three-year cliff, under which nothing vests until three years of service and then everything does, or a graded schedule reaching 100 percent after six years. Graded vesting rewards staying while giving departing employees something; cliff vesting is simpler but harsher. The partners chose a four-year graded schedule for profit sharing, 25 percent a year. As Week 3 explains, safe harbor matching contributions must vest immediately, so the schedule applies only to profit sharing.

Testing for Fairness

The tax code limits how much more highly compensated employees can defer and receive in matches than everyone else. Highly compensated employees include anyone who owns more than 5 percent of the firm and, for 2025, generally anyone paid more than $155,000 in the prior year. The deferral test compares the average deferral rate of that group with the average for others. If other employees defer an average of 4 percent, the highly compensated group may average no more than 6 percent. A similar test applies to matching contributions. At Ridgeline, where many younger staff would defer little in the first year, the partners could be forced to receive refunds of their deferrals.

Top-Heavy Rules

A plan is top-heavy when key employees, mainly owners and officers, hold more than 60 percent of plan assets. Because the partners would contribute heavily from the start, the plan would likely become top-heavy. Top-heavy plans must provide a minimum employer contribution, usually 3 percent of pay, to non-key employees and faster vesting.

The Safe Harbor Solution

A safe harbor 401(k) avoids the deferral and match tests if the employer makes a required contribution, fully vested, and gives employees advance notice. The common forms are a basic match, which pays a dollar for each dollar deferred on the first 3 percent of pay and fifty cents per dollar on the next 2 percent, an enhanced match of at least that amount, often 100 percent up to 4 percent, or a nonelective contribution of 3 percent of pay for every eligible employee. A plan whose only contributions are safe harbor contributions and deferrals is also exempt from the top-heavy rules, though adding profit sharing can bring them back. The partners chose an enhanced match of 100 percent up to 4 percent.

Automatic Enrollment

New 401(k) plans established after the end of 2022 generally must automatically enroll eligible employees beginning with plan years after 2024, at an initial rate of 3 to 10 percent rising by one point a year to at least 10 percent, with exemptions for businesses with 10 or fewer employees and those in existence less than three years. Ridgeline, with 26 people and a long history, must comply. The evidence supports the rule: Madrian and Shea (2001) found that automatic enrollment raised participation among new employees from 37 percent to 86 percent. The partners set the default at 4 percent, the amount that earns the full match.

Correcting Mistakes

New plans make mistakes, such as missing an employee's automatic enrollment or using the wrong pay to compute the match. The IRS offers correction programs that let sponsors fix many errors themselves, often by making a corrective contribution with earnings, before an audit. The partners asked the recordkeeper to run a payroll reconciliation each quarter so that errors are found early, when they are cheap to fix.

Reporting and Disclosure

The plan must file an annual Form 5500, distribute a summary plan description, send safe harbor and automatic enrollment notices before each year, provide fee disclosures and furnish benefit statements. The advisor prepared a calendar listing each deadline.

Conclusion

ERISA makes the partners fiduciaries with personal responsibility, and the tax code sets limits on eligibility, vesting and how much the plan can favor them. Within those limits, Ridgeline chose short waiting periods, part-time access, graded vesting for profit sharing and a safe harbor match that avoids the deferral tests. Automatic enrollment at 4 percent will bring most employees into the plan from the start.

References

Internal Revenue Service. (2025). 401(k) plan qualification requirements. https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-qualification-requirements

Madrian, B. C., & Shea, D. F. (2001). The power of suggestion: Inertia in 401(k) participation and savings behavior. The Quarterly Journal of Economics, 116(4), 1149-1187. https://doi.org/10.1162/003355301753265543

U.S. Department of Labor. (2021). Meeting your fiduciary responsibilities. Employee Benefits Security Administration. https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/publications/meeting-your-fiduciary-responsibilities