How Does a Prototype 401k Plan Work?

A prototype 401(k) plan is a retirement plan template from a financial institution, like a bank or mutual fund company, that is pre-approved by the Internal Revenue Service (IRS). The purpose of a prototype plan is to provide a streamlined structure, reducing the administrative burden and legal complexity of creating a plan from scratch. This approach offers a balance of established legal compliance with a degree of customization to fit a company’s specific needs.

Understanding the Plan Documents

A prototype 401(k) plan has two documents that form its legal foundation. The first is the Basic Plan Document, a comprehensive text created by the sponsoring financial institution. This master document contains all fixed provisions and outlines all possible features available under the template, and it carries an IRS opinion letter confirming its qualified status.

The second component is the Adoption Agreement, which the employer completes. This agreement is a checklist allowing the employer to select specific features from the options provided in the Basic Plan Document. The employer uses the Adoption Agreement to define eligibility, contribution types, and vesting schedules. The Basic Plan Document provides the IRS-approved framework, while the Adoption Agreement records the employer’s choices.

Customizing Your Plan with the Adoption Agreement

The Adoption Agreement is where an employer tailors the prototype plan to its goals. An employer must set eligibility requirements, specifying a minimum age, which cannot exceed 21, and the required period of service. Federal rules set the maximum service requirement at one year (a 12-month period with at least 1,000 hours worked). Plans must also allow participation for long-term, part-time employees who complete two consecutive years with at least 500 hours of service annually.

The employer also defines the types of contributions the plan will accept. This includes employee salary deferrals, where employees contribute a portion of their pre-tax or Roth (post-tax) compensation. The employer outlines its contribution formula, which could be a matching contribution or a non-elective contribution where the company contributes a percentage of every eligible employee’s salary.

Another selection is the vesting schedule for employer contributions, which determines when an employee gains full ownership of company-contributed funds. Options include a “cliff” vesting schedule, where an employee becomes 100% vested after a specific period like three years. An alternative is a “graded” schedule, where ownership increases incrementally until the employee is fully vested after six years.

The Adoption Agreement also specifies rules for accessing plan funds before retirement. The employer decides whether to permit participant loans, allowing employees to borrow against their vested account balance. The agreement dictates if the plan will allow for hardship withdrawals, which are distributions for an immediate and heavy financial need.

Standardized vs. Non-Standardized Prototype Plans

Employers must choose between a standardized and a non-standardized version of a prototype plan. A standardized plan is more restrictive, with its provisions structured to automatically satisfy annual IRS nondiscrimination tests. These tests, like the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, ensure the plan does not disproportionately benefit highly compensated employees.

Adopting a standardized plan provides a “safe harbor” from this annual testing, which simplifies administration. This simplicity comes at the cost of flexibility, as design features like eligibility and contribution formulas are often fixed. A standardized plan must cover all employees who meet age and service requirements and provide a minimum employer contribution that is 100% vested immediately.

A non-standardized plan offers greater flexibility, allowing an employer more control over the plan’s design, such as excluding certain employee classes or using complex contribution formulas. This adaptability means the plan does not automatically pass nondiscrimination requirements. The employer must conduct the ADP and ACP tests annually, and failure to pass requires corrective actions, like returning contributions to highly compensated employees.

The Plan Establishment Process

After completing the Adoption Agreement, an employer must take several steps to establish the plan. The employer must sign the Adoption Agreement before the end of the tax year for which the plan is to be effective. Following the signing, the employer must distribute a Summary Plan Description to all eligible employees, which explains the plan’s features and rules.

The employer must also establish a trust account to hold the plan’s assets, separate from the company’s general assets. This account is managed by a trustee for the benefit of plan participants, and all contributions are deposited into this trust.

For an additional level of assurance, an employer can file Form 5307 to request a determination letter from the IRS. This optional letter provides an official ruling that the plan, as customized by the employer, is qualified under federal law.