Designing and Administering Defined Contribution Retirement Plans

Retirement benefits can be a valuable tool for recruiting and retaining employees, but those benefits must be balanced with the cost to the employer of providing the benefits. Defined contribution plans provide the greatest cost control and design flexibility to employers while also providing employees with a retirement benefit they can easily understand. The administrative costs of a defined contribution plan may be borne solely by either the employer or the plan participants, or they may be shared.

This toolkit discusses the defined contribution plan design options available to employers and identifies related administrative issues.

Business Case

With the uncertainty surrounding the future of Social Security as a source of retirement income, employer-sponsored retirement benefits remain a significant part of both employees' total compensation and their considerations when deciding whether to accept a job.However, contributing to a retirement benefits program, and paying related administrative costs, can require a substantial portion of an employer's total compensation budget.

As a result, employers have a vested interest in designing and maintaining a retirement benefits program that balances the recruiting and retention benefits it generates with the costs incurred by, and financial liability imposed on, the employer.

See Help Employees Turn Retirement Savings into Lifetime Income.

Defined contribution plans are replacing defined benefit (pension) plans because they enable an employer to better control the amount it contributes, and they permit employees to participate more actively in the process of building a personal retirement fund. This is true for employers of all sizes in most industries. By carefully designing a defined contribution plan, employers can provide affordable retirement benefits to employees. 

An additional, and growing, purpose for providing employer-sponsored retirement programs is helping older workers feel financially secure enough to retire. Under saving in general coupled with the economic turmoil caused by the COVID-19 pandemic has negatively impacted many employees' confidence in their ability to retire comfortably. To recoup their losses, workers may be on the job for longer than they'd planned.

See COVID-19 Upends Retirement Expectations Across Generations and The COVID-19 Retirement Planning Crisis.

Types of Defined Contribution Plans

Defined contribution plans are retirement benefits plans under which the benefit payable to a participant at retirement is determined by the amount of contributions made to the plan on that participant's behalf, plus investment earnings on those contributions over time. The name of the plan is derived from the fact that the plan contributions, not the plan benefits, are defined by the plan.

In contrast, defined benefit plans are retirement benefits plans under which the benefit payable at retirement is specified in the plan, and the contributions required to fund those benefits fluctuate as necessary to ensure the plan has sufficient assets to provide the promised benefits.

See Types of Retirement Plans.

Examples of defined contribution plans are profit sharing plans, money purchase plans, employee stock ownership plans and 401(k) plans. According to SHRM's 2022 Benefits Survey, 94% of employers offer a traditional 401(k) or similar plan. Because this is by far the most common defined contribution plan offered by employers, this toolkit will focus primarily on the 401(k) plan.

Employer Contributions

The employer can choose whether to make no contribution, nonelective contributions or matching contributions. For both nonelective and matching contributions, the plan document may specify the amount of employer contributions to be made each plan year, or it may specify the formula that will be used to determine the amount of employer contributions that will be made.

To provide the employer with greater flexibility, a plan document is permitted to grant the employer the discretion to decide whether to make nonelective or matching contributions, or both, for each plan year. This feature gives the employer the greatest amount of flexibility in deciding the amount the employer can afford to contribute to the plan in any given year. The employer may decide how much its contribution will be at either the beginning or the end of the plan year, and a plan amendment is not required even if the contribution is different than the contribution made for the previous plan year. 

Decreasing the employer contribution requirements in the plan document generally requires amending the plan document before the time when the employer contributions must be allocated to participants' accounts. For example, if matching contributions are to be allocated to participants' accounts each payday, a plan amendment decreasing the amount of matching contributions can only be effective for paydays after the date the amendment is adopted; it cannot be applied retroactively.

See When Employers Must Cut Their 401(k) Contributions to Stay Afloat.

Nonelective Contributions.

Nonelective contributions are not conditional on an employee's election to contribute to the plan. Nonelective contributions are usually provided to eligible participating employees based on either a fixed or discretionary formula. Other approaches use the participant's age or years of service, or they provide the same dollar amount to each eligible participant.

Matching Contributions.

Matching contributions are employer contributions that are made to the plan accounts of only participants who elect to make employee contributions to the plan. Matching contributions are usually based on a formula under which the employer's contribution is equal to a percentage of the participant's employee contributions to the plan.

However, matching contributions can also be flat dollar amounts, usually up to a certain maximum percentage. According to Deloitte's 2019 Defined Contribution Benchmarking Survey Report, 85 percent of employers offer some form of matching contribution in their defined contribution plans.

See Consider 401(k) True-Up Payments for Employer Matching Contributions.

Design considerations

Employers should take into account a variety of factors in designing their plans.

See A Guide to Common Qualified Plan Requirements.

Nondiscrimination rules.

No employer contributions, either nonelective or matching, may discriminate in favor of highly compensated employees. The nondiscrimination requirements generally require annual testing of how the employer contributions that were actually made were allocated among participants. However, the employer contributions may be treated as automatically satisfying the nondiscrimination requirements if the method for allocating the employer contributions is specified in the plan document and the method complies with a safe harbor allocation formula provided in the Internal Revenue Code or related U.S. Treasury regulations.

Adopting a safe harbor allocation method reduces the administrative requirements for the plan and eliminates any inadvertent discriminatory allocations that could require retroactive correction and subject the sponsoring employer or the affected highly compensated employees to penalties.

See Small Businesses Favor Safe Harbor 401(k) Plans.

Although drafting the plan document to give the employer the discretion to decide the amount of, or formula for, employer contributions each year gives the employer the most financial freedom with respect to making employer contributions to the plan, it prevents the plan from satisfying any of the safe harbor options.

An employer exchanges relief from annual nondiscrimination testing for that financial freedom. Because satisfying a safe harbor may provide significant benefits to employers under some circumstances, an employer should carefully evaluate whether preserving full discretion within the plan document is more advantageous than qualifying for a safe harbor.

See Suspending Safe Harbor 401(k) Contributions: A Primer for Employers. 

Different contributions for different groups.

Within limits, it is possible to provide different employer contributions to different groups of employees. The employer contribution formulas for union and nonunion employees may differ if the employer contribution formula for the union employees was derived from a collective bargaining agreement. If different employer contribution formulas are provided for groups of nonunion employees, such as salaried employees and hourly nonunion employees, the employer contributions will need to be tested annually to verify that they do not discriminate in favor of highly compensated employees. Although it is permissible, using different formulas for determining employer contributions for different groups of employees requires additional administrative effort and expense.

Eligibility.

Employers may require an employee who is eligible to participate in the plan to complete a year of service before becoming eligible to receive employer contributions, even if the employee becomes eligible to make employee contributions at an earlier date. For example, an employee could be eligible to make employee contributions immediately when hired, but the employee could be required to complete a year of service before becoming eligible to receive matching contributions.

Historically, 401(k) plans could exclude individuals who worked less than 1,000 hours in the plan year. However, the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, in its effort to expand access to employer retirement plans, introduced the concept of a "long-term, part-time employee."

For plan years beginning after Dec. 31, 2023, employers must allow long-term part-time workers to make elective deferrals to the employer-sponsored 401(k) plan, except in the case of collectively bargained plans. Eligible employees are those who have completed at least 500 hours of service each year for three consecutive years and are age 21 or older. Years of service prior to 2021 do not have to be counted; however, employers may choose to have more generous eligibility rules. The 2023 Consolidated Appropriations Act (also known as the Secure Act 2.0) reduces the three consecutive years of service to two years for plan years beginning after Dec. 31, 2024.

For eligibility purposes, only those years after 2021 are counted. The first year any long-term, part-time employee will be required to be eligible for the 401(k) Plan is 2024. Plans can be more generous and allow entry into the plan sooner. See Who Is a Long-Term, Part-Time Employee? 401(k) Plans Will Need to Know and Long-Term, Part-Time Employee Rules for Cash or Deferred Arrangements Under Section 401(k).

Employee Contributions

Four types of employee contributions exist: pretax, after tax, Roth individual retirement arrangement (IRA) and rollovers.

Pretax. The most common employee contributions to 401(k) plans are pretax contributions made by employees who elect to reduce their taxable compensation and to have the employer contribute that amount to the plan on their behalf. Only Federal Insurance Contributions Act (FICA) payroll taxes are withheld from an employee's pretax contributions to a defined contribution plan; income taxes are deferred until the pretax contributions are later distributed from the plan.

After tax. Employees may also make after-tax contributions if the plan allows. As the name implies, these contributions are deducted from an employee's compensation after all payroll and income taxes have been deducted. When these contributions are later distributed from the plan, the employee does not pay income tax again on these contributions (but the employee does pay income tax on any investment earnings associated with the after-tax contributions).

Roth IRA. A plan can permit participants to make contributions to a Roth account within the plan. Roth contributions are made on an after-tax basis, but earnings on the Roth contributions can be distributed on a tax-free basis if the conditions for a qualified Roth distribution are satisfied. A participant's Roth contributions are combined with the participant's pretax contributions for purposes of the annual Internal Revenue Service (IRS) limits on pretax contributions and catch-up contributions.

Rollovers. A plan can also accept rollover contributions from other qualified retirement plans or IRAs. By allowing participating employees to roll over these contributions, the participants can consolidate all of their retirement savings in one place. It also increases the total assets of the plan, which may enable the plan to qualify for investment option classes with lower expense ratios and to qualify for lower plan administrative fees.

Design considerations

Administering a 401(k) plan that allows employee contributions of any type requires monitoring limits on those contributions and testing the plan to make sure that employee contributions are not disproportionately made by highly compensated employees. The nondiscrimination testing can be eliminated if the employer makes nonelective or matching contributions that satisfy specific safe harbor requirements.

The amount of pretax and Roth contributions that an employee can make to all of the defined contribution plans in which the employee participates in a calendar year is limited by the Internal Revenue Code. Employees who are at least age 50 by the end of each plan year may make additional catch-up contributions of pretax or Roth contributions, or both in combination, up to an amount prescribed by the Internal Revenue Code.

See For 2023, 401(k) Contribution Limit Rises to $22,500 with $7,500 'Catch-Up' and COLA Increases for Dollar Limitations on Benefits and Contributions.

After-tax contributions made by highly compensated employees may be limited by the applicable nondiscrimination testing unless the employer contributions to the plan satisfy a safe harbor. 

A plan is not required to permit all of these types of employee contributions. However, many plans permit both pretax and after-tax contributions to allow participating employees to make the types of contributions that best suit their individual income tax situations. If more than one type of employee contribution is permitted, the plan's record-keeping system must separately track each type of contribution and the related investment earnings.

See How long does an employer have to deposit 401(k) contributions withheld from employee's paychecks?

Automatic Enrollment and Contributions

An automatic contribution arrangement (also known as automatic enrollment or auto enroll) is a retirement plan feature that allows employers to enroll eligible employees in the plan automatically unless the employee affirmatively elects not to participate. This approach encourages retirement savings and can significantly increase participation in the employers 401(k) plan.

According to a 2019 Deloitte survey, 69 percent of plan sponsors include an automatic enrollment feature with three or six percent being the most common default deferral percentages. Employers also have the option of implementing an automatic increase in employee contributions, with an increase of 1 percent per year most common. 

New 401(k) plans established after Dec. 31, 2024, must include automatic enrollments for all eligible participants at no less than 3 percent and no more than 10 percent of qualifying earnings, with automatic 1 percent increases annually up to a maximum limit set between 10 percent and 15 percent. Participants may opt out and may recoup contributions within 90 days of the start of automatic enrollment without penalty. Exempt from these requirements are existing plans, SIMPLE plans, employers with 10 or fewer employees and new employers in existence for less than three years.

See Secure 2.0 Retirement Overhaul on Track and Retirement Plans FAQs Regarding Automatic Contribution Arrangements (Automatic Enrollment Arrangements).

Vesting of Employer Contributions

Employer contributions to a defined contribution plan become vested when the participant has a nonforfeitable right to some or all of the employer contributions if the participant terminates his or her employment. The structure of a plan's vesting schedule is limited by the Internal Revenue Code.

Alternatives to offering immediate vesting in the plan are cliff or graded vesting schedules. Employer contributions are subject to a three-year cliff or a two to six-year graded vesting schedule.

Cliff vesting. Under a cliff vesting schedule, the employee has no vested interest in any employer contributions until the employee completes the required number of years of service. At that point, the employee becomes 100 percent vested in all past and future employer contributions. In general, a cliff vesting schedule cannot require a participant to complete more than three years of service before the participant becomes 100 percent vested in all past and future employer contributions. However, a plan may require an employee to complete two years of service before becoming eligible to receive employer contributions, but only if all employer contributions are 100 percent vested beginning when the employee completes the two years of service and becomes eligible for employer contributions.

Graded. Under a graded vesting schedule, the participant's vested percentage in the employer contributions starts at less than 100 percent and increases with each year of service. A graded vesting schedule must provide for at least 20 percent vesting after completing two years of service and must increase the vested percentage by at least 20 percent for each additional year of service completed, so that the participant is 100 percent vested after completing no more than six years of service.

The IRS provides the following vesting examples:

Design Considerations

An effective design of a defined contribution plan's vesting schedule can encourage retention, but only if the employer contributions to the plan are significant enough so that losing the unvested amount will be a deterrent to an employee's leaving. Cliff vesting requires an employee to remain employed for, at most, three years before becoming vested in any portion of his or her employer contributions; if the workforce longevity averages less than three years because of voluntary departures, cliff vesting may encourage employees to remain employed for a longer period of time. A graded vesting schedule, while providing for partial vesting, delays full vesting for up to six years of service.

As with employer contributions, different vesting schedules may be established for union and nonunion employee groups if the union vesting schedule is negotiated. Different vesting schedules among groups of nonunion employees are subject to nondiscrimination testing to demonstrate that more favorable vesting schedules are not disproportionately available to highly compensated employees.

If the employer's nonelective or matching contributions are used to satisfy a safe harbor and to relieve the plan from nondiscrimination testing of employee or employer contributions, the employer contributions must be 100 percent vested immediately. This trade-off needs to be evaluated by an employer that is considering taking advantage of a safe harbor.

In most cases, the value of not reducing employee or employer contributions made by or on behalf of highly compensated employees, which is the purpose of satisfying the safe harbor, must be weighed against the employer contributions made on behalf of employees who are not highly compensated and who leave employment before they would otherwise be vested in the employer contributions if a vesting schedule were applied.

Investment of Participants' Accounts

The assets held in a defined contribution plan must be appropriately invested. The plan administrator will have fiduciary obligations under the Employee Retirement Income Security Act (ERISA) with respect to the investment of plan assets under either approach. See Retirement Plan Fiduciary Responsibilities and Administering a 401(k) Plan: Who Does What?

There are two basic approaches to allocating responsibility for investment of the plan's assets: participant directed and administrator directed.

Participant Directed

The most common approach for directing the investment of plan assets is to give each participant the authority and responsibility to direct the investment of his or her own plan account. This approach allows each participant to make investment decisions that reflect his or her own risk tolerance, expected investment horizon and other retirement assets outside of the plan.

The plan administrator may reduce its exposure to ERISA fiduciary liability for the participant's investment choices by complying with a specific set of requirements under §404(c) of ERISA, which addresses the frequency with which the participant can change investment elections, the range of investment options offered to the participant and the information provided to the participant on the investment options. 

See Number of 401(k) Funds Offered to Plan Participants Shrinks.

A variation on allowing participants to direct the investment of their own plan accounts is to provide access to a qualified investment advisor, to whom participants may elect to give control over the investment of their accounts. If the plan administrator selects the investment advisor, the plan administrator is subject to ERISA fiduciary duty requirements with respect to the selection and retention of that investment advisor.

See DOL Finalizes Less-Restrictive Fiduciary Standard for Investment Advice.

Administrator Directed

The other option is for the plan administrator to retain full investment control over all of the assets in the plan. Under this approach, individual participants are not permitted to direct the investment of any plan assets allocated to their accounts. The plan administrator has full ERISA fiduciary responsibility and potential liability for the investment of the plan's assets. See Final Rule Limits 401(k)s from Picking Funds Based on Nonfinancial Factors.

Combined

These options can be combined. Participants may be permitted to direct the investment of a portion of their plan accounts (for example, the portion that they contributed), and the plan administrator retains investment authority and responsibility for the remainder of the plan assets. 

Design Considerations

With respect to investment of a plan's assets, the plan administrator will never fully escape all potential liability for breach of its ERISA fiduciary duties. If investment authority is given to plan participants, the plan administrator remains responsible for selecting the investment options made available to plan participants and for monitoring those options to ensure that they remain appropriate options. Those selection and monitoring actions are subject to the ERISA fiduciary duty rules.

In addition, the plan administrator will be required to specify a default investment option into which a participant's account will be invested if the participant does not provide any investment directions; the selection of the default investment option is also a fiduciary act under ERISA.

Because the investment of plan assets by anyone other than a plan participant is a fiduciary act subject to ERISA, the plan administrator will be exposed to ERISA fiduciary liability if the plan administration retains direct responsibility for investing plan assets and does not exercise that responsibility in compliance with ERISA fiduciary duties.

If participants are allowed to direct the investment of their entire plan accounts, the plan administrator can obtain some protection by complying with the requirements of §404(c) of ERISA. Administering participants' investment elections for their plan accounts and complying with those requirements will generally always require the assistance of an outside service provider.

Few employers that sponsor defined contribution plans do not allow participants to direct the investment of their plan accounts; an employer that decides not to allow participants to direct the investment of their plan accounts should expect to face resistance from employees.

However, employers should still carefully evaluate the ability of their workforces as a whole to appropriately invest their plan accounts to support their retirement income goals and needs before deciding if giving this responsibility to their participants is in the participants' best interests. As a general rule, the right to direct the investment of a participant's account cannot be granted to some groups of employees and not to others (with the exception of the union/nonunion distinction). 

Loans and In-Service Withdrawals

A plan may permit participants to take loans against their account balances and may allow for limited withdrawals while an employee is still actively employed. See IRS Hardships, Early Withdrawals and Loans.

A plan sponsor may allow all, some or none of the following options.

Loans

Loans that are collateralized by a participant's plan account may be made for any amount up to limits imposed by the Internal Revenue Code and ERISA. Generally, all outstanding loan balances during any 12-month period cannot exceed the lesser of $50,000 or 50 percent of the participant's account balance.

An exception to this limit is if 50 percent of the vested account balance is less than $10,000. In such case, the participant may borrow up to $10,000. There is no legal limit on the number of loans a participant may have outstanding at any time, as long as the total outstanding loan balances satisfy the stated limits; however, the plan can administratively limit the number of outstanding loans available to a participant. Loans cannot have a term of more than five years unless the loan is to purchase the participant's principal residence, in which case the term is not limited. Loans must bear a commercially reasonable rate of interest.

In-Service Withdrawals Before Age 59 1/2

A plan may permit in-service withdrawals on request before a participant attains age 59 1/2 from after-tax contributions made by participants and employer contributions (if the employer contributions have been credited to the participant's plan account for at least 24 months). The plan may specify limits as to the frequency and number of in-service withdrawals.

Hardship Withdrawals

A plan may also permit in-service withdrawals before a participant attains age 59 1/2 if the participant incurs a severe financial hardship that satisfies requirements established by the Internal Revenue Code and related U.S. Treasury regulations. Restrictions apply to the amount that may be withdrawn. Starting Jan. 1, 2020, plans are no longer be able to suspend contributions following a hardship distribution. See IRS Final Rule Eases 401(k) Hardship Withdrawals, Requires Amending Plans.

Birth or Adoption Withdrawals

 Under the SECURE Act, employers are permitted to allow qualified birth or adoption distributions (QBOADs) as of Jan. 1, 2020. A plan that allows QBOADs permits plan participants to take distributions of up to $5,000 as a penalty-free early withdrawal to help cover expenses related to the adoption or birth of a child. The maximum $5,000 distribution must be made during the one-year period following the birth or adoption, and plan participants that make such a withdrawal are permitted to recontribute the distribution to the plan. See IRS Notice 2020-68

Withdrawals After Age 59 1/2

After a participant reaches age 59 1/2, the participant may be permitted to withdraw any portion of his or her account.

Automatic rollover or portability. 401(k) plan sponsors can automatically roll over a former employee's 401(k) balance of up to $5000 ($7,000 effective Jan. 1, 2024) to a safe harbor IRA or transfer small balance 401(k) funds to the individual's new employer's 401(k) plan. See DOL Eases Automatic Transfer of Left-Behind 401(k) Dollars to New Plans.

Design Considerations

If the employer's intent is to encourage employees to save for retirement, allowing loans and in-service withdrawals works against that goal by allowing employees to deplete their retirement savings before retirement. However, participants may be more willing to participate in the plan and make their own contributions to the plan if they know they can access their plan accounts when needed, within the constraints imposed by law.

An employer should assess the needs of its workforce when deciding whether its plan should allow loans or in-service withdrawals, and if they are permitted, what limits will be imposed. Employers are not obligated to offer any of these options. It is also permissible for a plan to impose limits that are more restrictive than those imposed by the Internal Revenue Code or ERISA.

For example, a plan could limit a participant's total outstanding loan balances during any 12-month period to not more than the lesser of $25,000 or 25 percent of the participant's account balance, or it could allow in-service withdrawals only for financial hardships. Other forms of plan distributions are also available. See When Can a Retirement Plan Distribute Benefits?

Legal Issues

Federal laws

The design and operation of tax-qualified retirement plans, including defined contribution plans, are strictly and extensively regulated by two federal laws: the Internal Revenue Code (primarily Part I of Subchapter D of Chapter 1) and ERISA. In addition, a multitude of related regulations and government agency pronouncements may apply.

Many of the applicable sections of the Internal Revenue Code and ERISA are identical; under Reorganization Plan No. 4 of 1978, enforcement responsibility for these duplicated legal requirements was assigned to the U.S. Department of the Treasury, as implemented by the IRS. The Employee Benefits Security Administration (EBSA) of the U.S. Department of Labor is responsible for enforcing reporting and disclosure requirements in ERISA that are not duplicated in the Internal Revenue Code, in addition to the statutory duties imposed on plan fiduciaries under ERISA.

Both the IRS and the EBSA are active in enforcing their respective obligations. The EBSA focuses more on a plan's relationship with its participants, including required disclosures to participants and participants' claims for plan benefits, as well as on the management of a plan and its assets by the plan's fiduciaries. The IRS focuses primarily on the plan's compliance with the applicable nondiscrimination requirements and on ensuring that the plan document both includes all mandated statutory and regulatory provisions and is administered in compliance with those provisions.

In general, complying with the legal requirements enforced by the IRS is necessary to secure and preserve the tax-favored treatment of benefits provided under a qualified defined contribution plan. In contrast, complying with the legal requirements enforced by the EBSA is necessary to avoid the imposition of penalties on the plan administrator and the individuals with the authority and responsibility for operating the plan.

State Mandates

At least 10 states currently have requirements for certain private employers to offer a retirement plan to employees. For example, California employers that do not already have a workplace retirement plan must participate in the CalSavers program to provide employees access to a retirement savings option. Similarly, Illinois employers with 25 or more employees must participate in the Secure Choice program.

COVID-19 Relief

Several pieces of legislation were passed in response to the COVID-19 pandemic that impact defined benefit plans; some offering employers and participants temporary relief due to the impact of the virus.
See:
Appropriations Act Eases Retirement Plan Rules
How the CARES Act Changes Health, Retirement and Student Loan Benefits

Communications

ERISA mandates certain communications with defined contribution plan participants, including summary plan descriptions and annual reports on the plan's financial activity.

Additional disclosures to plan participants are required under the Internal Revenue Code under certain circumstances, such as when the plan satisfies a safe harbor to avoid nondiscrimination testing of employer contributions or if the plan automatically enrolls newly eligible participants to make employee contributions to the plan.

Communicating with plan participants about the terms of the plan is an activity subject to the fiduciary responsibility requirements under ERISA. HR professionals charged with drafting communications to plan participants or with dealing directly with plan participants on plan issues need to make sure those communications are accurate, complete, objective and carefully drafted or phrased to be understandable by average plan participants.

See:
Reporting and Disclosure Guide for Employee Benefit Plans
DOL Final Rule Will Shift 401(k) Participant Disclosures Online
7 Tips for Managing Your Company's 401(k)
Year-End Compliance Update for Retirement Plans

Additional Resources

Tools and Samples

401(k) Plan Employee Presentation (PPT)
401(k) Automatic Enrollment Election for New Hires
401(k) Notice of Mandatory Distribution
401(k) Plan Policy: Eligibility and Contributions

 
Government Resources

401(k) Plan Checklist
A Look At 401(k) Plan Fees
401(k) Plan Fix-It Guide
IRS Tax Information for Retirement Plans
FAQs about Retirement Plans and ERISA
Consumer Information on Retirement Plans
EBSA Retirement Plan Compliance Assistance
Federal Compliance Resources