Starting a 401k? A Short Initial Plan Year is Probably a Bad Idea

401(k) plans must define a 12-month “plan year” for annual administration purposes. Most plans choose a calendar year for administrative ease. A new plan can specify a period that’s shorter than a full 12-months for its initial plan year by choosing a mid-year effective date. However, establishing a short plan year with a mid-year effective date is often a bad idea. Most plans are better off making their effective date retroactive to the first day of the normal plan year - January 1 in the case of a calendar-based plan – to establish a 12-month initial plan year.

The reason? A full 12-month plan year will probably mean larger contributions for plan participants and less administrative complexity for employers. 

As a business owner, picking an effective date for a new 401(k) plan can seem like an insignificant decision during the plan design process. In fact, the date you choose could dramatically affect your new plan’s first year administration. You probably don’t want a short initial plan year. Here’s why.

401(k) Administration Issues Created by a Short Plan Year

When a new 401(k) plan has a short initial plan year, a number of administrative issues arise. Here’s a summary of the major ones.

Issue

Effect of a Short Plan Year

Plan Compensation

All 401(k) plans must define “plan compensation” – basically, the compensation to be used when allocating contributions to plan participants. Most plans base their definition on W-2 wages for administrative ease. Plans must also specify the period for determining plan compensation. 

Many plans specify the plan year. When a short plan year applies, these plans must limit their plan compensation to the short period. That usually means: 

  • Smaller annual contributions for plan participants
  • A special compensation calculation for employers

These outcomes are often an unwelcome surprise for business owners when they apply. 

401(a)(17) Limit

401(k) plans cannot base contributions on compensation that exceeds the IRC Section 401(a)(17) limit in effect for the plan year. The compensation used for nondiscrimination testing purposes must also be capped by this limit. For 2021, the limit is $290,000.

The 401(a)(17) limit applies for a 12-month period. When plan compensation is based on a short plan year, the 401(a)(17) limit must be prorated based on the number of months in that year.

For example, the 401(a)(17) compensation limit for a short plan year spanning October 1, 2021 to December 31, 2021 would be $72,500 ($290,000 * (3/12)).

In general, a prorated 401(a)(17) limit makes nondiscrimination tests harder to pass – which means lower contributions for Highly-Compensated Employees (HCEs).

415(c) Limit

IRC Section 415(c) limits the total contributions a 401(k) plan can make to each plan participant during the “limitation year.” For 2021, the 415(c) contribution limitis the lesser of: 1) $58,000 ($64,500 for catch-eligible participants), or 2) 100% of gross compensation.

Many 401(k) plans define the limitation year as the plan year. When a short plan year applies, these plans must prorate the 415(c) contribution limit based on the number of months in the year.

For example, the 415(c) contribution limit for a short limitation year spanning October 1, 2021 to December 31, 2021 would be $14,500 ($58,000 * (3/12)).

While it’s not difficult to avoid a prorated 415(c) limit when a short plan year applies – a plan just needs to define the limitation year as something different than the plan year – it’s one more thing to think about.

Employee Eligibility

401(k) plans have two options for measuring employee service for plan eligibility purposes - elapsed time and counting hours. As their names imply, the elapsed time method measures time, while the counting hours method measures hours worked (usually within a specified period).

In general, a short plan year won’t affect either method because 401(k) plans can’t disregard service earned prior to their effective date for eligibility purposes.

Contribution Vesting

Like eligibility, 401(k) plans can measure years of service for contribution vesting purposes using the elapsed time or counting hours method.

Unlike eligibility, 401(k) plans can disregard service earned prior to their effective date for vesting purposes. However, this choice can complicate the years of service calculation when a short plan year applies because vesting computation periods can be no less than 12 months long.

Contribution Allocations

401(k) plans can require participants to work a specified number of hours each plan year to receive a year-end (non-safe harbor) matching and profit sharing contribution. A 1,000 hours of service requirement is most common. 

Plans have no legal obligation to reduce an allocation requirement during a short plan year. If a plan’s normal hours requirement will be a problem during a short year, it must be reduced explicitly in the plan document for the year.

HCE Determination 

When determining Highly-Compensated Employees (HCEs) for a plan year, 401(k) plans must consider the compensation earned by employees during the “lookback” year – the 12-month period immediately preceding the start of the plan year.

When a short plan year applies, the lookback year will probably straddle two tax years – which often makes the HCE determination process more difficult.

Avoid Disappointment Down the Road! 

There are few good reasons for business owners to choose a short initial plan year for a new 401(k) plan. In fact, there may only be one - to minimize the cost of a mandatory safe harbor or top heavy contribution. Most business owners will be happier with a 12-month initial plan year.

To make that happen, you must pick an effective date that’s retroactive to the first day of the normal plan year - January 1 in the case of a calendar-based plan.