Rehired employees present challenges to employers with company-sponsored retirement plans. Unfortunately, the treatment of rehires depends on many factors including how hours of service are determined under the plan, the plan’s specific eligibility provisions, and the specific provisions regarding vesting of participant accounts. There is not a “one size fits all” solution for how rehires are treated for purposes of the retirement plan(s) maintained by the employer, but there are specific items to be aware of when rehiring a former employee.

Benefits professionals frequently have to grapple with retirement plan issues regarding the eligibility of an employee that has been rehired. Many larger 401(k) plans provide for immediate entry into the plan and include 100% immediate vesting on all employer contributions. If that is the case—and there are no automatic enrollment provisions in the plan—the direction is very simple. However, many 401(k) plans include minimum service requirements or vesting schedules on employer contributions, which complicate the analysis. In addition, the automatic enrollment mandate for non-grandfathered plans which became effective January 1, 2025 makes the treatment of rehires even trickier.

The proper approach to addressing rehired employees can be found in the plan document, including the adoption agreement and any amendments to the plan (mandatory or discretionary). Nonetheless, while the plan document holds the answers, interpreting and understanding what that verbiage means is an entirely different matter. Understanding some basic rules is helpful as a starting point in this process, but it is always best to consult with a subject matter expert and to rely upon the plan’s service providers to avoid potential plan operational failures.

Methods of Calculating Service

There are three basic methods for calculating an employee’s service for retirement plan purposes:

• Actual Hours
  The Actual Hours method calculates the total hours of service worked or the hours an employee is compensated for, even when no services are performed. These hours encompass any time the employee is entitled to payment for services rendered to the employer, such as vacation, holidays, paid time off (PTO), sickness, and jury duty, among others. It also includes periods when the employee is not actively performing duties for the employer.

• Elapsed Time
  The Elapsed Time method depends on a start date and an end date for crediting service to an employee. The start date begins when an employee has first performed an hour of service for the employer. The end date is generally the date the employee ceases to perform services for the employer due to death, retirement or termination of employment.

• Hours Equivalencies
  The Hours Equivalency method allows employers to credit employees with hours based on days, weeks and months. The Department of Labor regulations indicate that an employee is granted the full credit for any of the following as long as one hour of service is performed during the period.

  • Days – Credit is 10 hours of service per day

  • Weeks – Credit is 45 hours per week

  • Months – Credit is 190 hours per month
    
    To illustrate the monthly equivalency application, if an employee only performs one hour of service in a month before terminating employment, the employee is still credited with 190 hours of service for that month. While the equivalency method has the advantage of being easy to apply, it may frequently result in employees being credited with more hours of service than actually performed.

Service, regardless of the method used, includes hours performed by a related employer, even if that related employer is not participating in that specific retirement plan. In addition, the plan document may state that different methods apply to different groups of employees. For example, the document may state that the actual hours method is used for hourly paid employees and that the equivalency method is used for salaried employees.

Service Computation Periods

Hours of service calculations for an employee may affect multiple aspects of participation including the employee’s eligibility to participate in the plan (if service is required for entry), vesting of employer contributions (assuming there is a vesting schedule), and allocations of employer contributions (if the plan requires service in a plan year to share in any company provided contributions).

Currently, the most restrictive eligibility requirements for a 401(k) plan are the attainment of age 21 and the completion of a Year of Service. “Year of Service” is a defined term in the plan document and is generally the completion of 1,000 hours of service in a 12-month period. That 12-month period may be based on either the Plan Year or Anniversary Year. 1,000 hours of service is the statutory maximum number of hours that can be used for earning a Year of Service. If a plan uses the elapsed time method for tracking hours of service, the term “Year of Service” is substituted with “One Year Period of Service.”

• Plan Year – The 12-month computation period is based on the Plan Year (typically the calendar year). However, the initial computation period is 12 months from an employee’s original date of hire to the anniversary date of the date of hire, then switches to the plan year in which the anniversary date falls. Plans that count actual hours for service commonly use the plan year for determining years of service because hours are typically tracked through payroll to coincide with the plan/calendar year.

  • Example – Date of Hire is March 20, 2024, plan runs on a calendar year basis

  • Initial computation period is March 20, 2024 to March 19, 2025

  • Second computation period is January 1, 2025 to December 31, 2025 (year that includes March 20, 2025)

  • Note: If the employee completes 1,000 hours during each of the initial and second computation periods, the employee is credited with two years of service.

• Anniversary Year – The 12-month computation period is based on each anniversary date from the employee’s original date of hire. Use of the Anniversary Year computation period is common in plans that use the Elapsed Time method for calculating hours of service. Each 12-month period of service is used to determine eligibility for plans with a one-year eligibility requirement.

  • Example – Date of Hire is March 20, 2024, plan runs on a calendar year basis

  • Initial computation period is March 20, 2024 to March 19, 2025

  • Second computation period is March 20, 2025 to March 19, 2026

  • Note: Continuous employment is not required during the measurement periods as the calculation is based on elapsed time rather than a specified number of actual hours

Treatment of Rehired Employees

One distinction to understand about counting service (regardless of methods used), is that all service with an employer is counted for eligibility, but the same is not true regarding vesting. As noted above, service with all related employers is counted for purposes of crediting hours of service. That concept is particularly relevant in mergers and acquisitions, as predecessor service must be credited when there is a business transaction that includes the purchase of the stock of another entity or when two or more entities are merged.

As a general rule, if a former employee is rehired and they previously satisfied the eligibility requirements and were employed on the applicable plan entry date, most plan documents will state that the employee is immediately eligible to begin participating in the plan upon rehire. And of course many large employer plans provide for immediate eligibility to participate in the 401(k) plan, in which case rehires are treated the same with eligibility immediately upon rehire.

Imposition of the age 21 and one year (or period) of service requirements is more common in the smaller plan market. In those cases, the first question is whether or not the employee both satisfied the eligibility requirements and the entry date requirements. If the answer is yes to both, then that employee will generally be eligible immediately upon rehire.

There are two other scenarios that can be difficult to administer. The first is when an employee terminates before satisfying the plan’s eligibility criteria. If that is the case, the rehire will need to satisfy the eligibility and entry date requirements upon rehire. The second is when an employee satisfies the eligibility criteria but terminates before the entry date. If the employee has not incurred a one-year break in service (more on that concept below), the rehire would be eligible upon the later of the rehire date or the plan’s entry date.

Special Rules regarding Eligibility following a Break in Service

Generally, an employee’s entire service history must be counted for eligibility. However, under the break-in-service rules, a plan may disregard certain periods of service. As if the service rules were not complicated enough, there are a few terms to note when discussing service crediting:

• One-Year Break in Service – For plans that use actual hours for service, a one-year break in service is a computation period (anniversary dates of hire or the plan year) in which the employee completes fewer than 501 hours of service.

• One-Year Period of Severance – For plans that use the elapsed time method for counting service, a one-year period of severance is similar to the one-year break in service except that the period for determining the break runs from the employee’s date of termination through the one-year anniversary date of termination. If that employee does not work at least one hour during that 12-month period, the employee would have a one-year period of severance.

• One-Year Hold Out – Infrequently used in 401(k) plans but worth noting, some plans may contain provisions for a one-year hold out of eligibility upon being rehired following a break in service (period of severance). Simply put, if an employee who was previously a participant in the plan terminates employment and is rehired after a break in service, the plan can require that they complete a year of service subsequent to being rehired before being considered eligible for the retirement plan.

• Rule of Parity – The rule of parity applies to eligibility following five consecutive one-year breaks in service. The plan document must include the election to use the rule of parity (and many do not) and only applies if the participant was unvested (that is 0% in all contributions sources). If the rehired employee had previously made deferrals to the plan (which are of course always 100% vested), this rule does not apply, which is why it is not common in 401(k) plans. The short version of this rule is if an employee returns after multiple breaks in service, prior service is counted unless there are five or more consecutive breaks, or the number of years of breaks exceed the years of prior service.

Special Rules regarding Vesting following a Break in Service

• One-Year Break in Service - A participant incurs a one-year break if they fail to complete more than 500 hours of service during a given period. Under the elapsed time rule, a break is defined as a continuous 12-month period without service, regardless of the number of hours worked.

• One-Year Hold Out - If a participant has a one-year break in service, prior service may be excluded for vesting purposes until the participant completes a year of service after returning. For example, if an employee returns after a two-year break in service, their previous service doesn't count toward vesting until they complete one year of service after rehire.

• Five One-Year Breaks - If a participant has five consecutive one-year breaks in service, any pre-break service is no longer counted for vesting. If a participant returns to work after this period, the previously unvested portion of their account is forfeited. This rule applies regardless of their vesting status before the break.

• Cash-Out Rule - A plan can disregard vesting service if a participant receives a full distribution of their vested account balance upon termination. However, the participant must be allowed to repay the distribution to restore their forfeited amounts. Repayments must be made within a certain period (e.g., five years after rehire).

• Rule of Parity - The rule ensures that a participant's prior service counts toward vesting if they return to work before (5) five consecutive one-year breaks. If the participant has more than five one-year breaks or the length of breaks exceeds the pre-break service, the prior service is disregarded for vesting.

Automatic Enrollment

Head spinning? Great, next up is what to do with a rehire if the retirement plan includes automatic enrollment and/or auto escalation. First, refer to the terms of the plan document to determine to whom the automatic enrollment provisions apply. Secondly, refer to the administrative procedures regarding automatic enrollment to determine how rehired employees are to be treated. Lastly, refer to the deferral election procedures specific to the plan. If the Plan Administrator does not have administrative procedures documenting how the automatic enrollment and auto escalation provisions will apply to rehires, now may be a great time to adopt such procedures.

Automatic enrollment plans come in different flavors including plans with Automatic Contribution Arrangements (ACA), Qualified Automatic Contribution Arrangements (QACA) and Eligible Automatic Contribution Arrangements (EACA). Effective January 1, 2025, plans that were not grandfathered (adopted before December 29, 2022) must include the Automatic Enrollment and Automatic Escalation provisions mandated under SECURE 2.0. Non-grandfathered plans must include EACA provisions and rehired employees will be affected by the addition of the EACA.

What should be done if an employee is rehired when the plan contains automatic enrollment?

1. Determine when the rehire is eligible to participate in the plan. In many cases the employee will be immediately eligible for the 401(k) plan upon the rehire date.

2. Determine if the employee previously had an affirmative election in place (opting out also qualifies as an affirmative election).

3. If the employee was previously automatically enrolled, it is likely that the automatic enrollment provisions will apply to the rehired employee. The automatic enrollment may be at the escalated rate rather than the initial default rate, depending on the amount of time that the employee was terminated.

4. Consult with the plan’s service provider to assist in determining how the rehired employee should be treated under the automatic enrollment provisions. Confirm whether the deferral agreement in place prior to termination is still applicable.

Also keep in mind that service providers may have default provisions in the plan’s automatic enrollment terms for rehired employees. For example, the plan may default to having the rehired employee auto enrolled upon rehire or the deferral rate reinstated upon rehire—and the options may vary depending on if the plan is a QACA or an EACA.

Conclusion

Addressing eligibility, entry, and vesting for rehired employees can be complicated depending on the specific terms of the plan. The information provided here is merely a guide to understanding how the service crediting rules vary across plans. Every situation will be different depending on the facts and circumstances and should be discussed with the plan’s service providers to make an actual determination regarding the employee and to prevent missed deferral opportunities.

Newfront Retirement Services guides plan sponsors through these difficult plan provisions and can assist in deciphering complicated plan terminology. Feel free to contact me or just connect to keep up to date on all things ERISA and 401(k): Joni_LinkedIn

Helpful Links:

• 401(k)ology – Related Employers

• 401(k)ology – Missed Deferral Opportunities

• Retirement topics – Automatic Enrollment

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