401(k) Plan Design: A 6-Step Checklist for Small Businesses

There is no such thing as a one-size-fits-all 401(k) plan. Small businesses have dramatically different goals — some owners want to maximize their own contributions at the lowest overall cost, others want to give employees a reason to save, or a reason to stay. Matching those goals to the available 401(k) options is called plan design.

Taking a design off the shelf is quicker, but the convenience can be expensive. A plan that does not fit your goals can cap what you defer as an owner, refund contributions to your highly compensated employees after the year is over, saddle you with a top-heavy contribution you never budgeted for, or commit you to an employer contribution that buys little goodwill with the people receiving it. Problems like these tend to surface after the plan year closes, when fixing them costs money.

The good news is that plan design is not as intimidating as it looks. Only five plan features are selected during the process — eligibility, compensation, contributions, vesting, and distributions and loans. Everything else in a plan document — which can run well past 100 pages — is boilerplate your 401(k) provider handles.

We address those five features in a 6-step process. You can use it to design a new plan or to evaluate an existing one like a professional, in 30 minutes or less. A checklist at the end lets you record your choices and hand them to your provider.

Step #1 – Define the "Employer"

401(k) plans must pass certain nondiscrimination tests annually to prove they do not disproportionately benefit your Highly-Compensated Employees (HCEs). The coverage test is one of them. To pass it, a plan must cover a sufficient percentage of non-Highly Compensated Employees. The consequences for failing can be severe — including retroactive contributions to employees, the taxable return of prior-year contributions, and plan disqualification.

Related employers — members of a controlled group or an affiliated service group — are considered a single employer for purposes of the coverage test. Often, a 401(k) plan must cover the employees of all related members to pass.

So if you have an ownership interest in two or more businesses, you need a clear understanding of their controlled or affiliated service group status before you choose a single plan feature. These determinations turn on attribution rules that are easy to misread. Have an ERISA attorney or your CPA make the call rather than deciding it yourself.

Step #2 – Choose a Safe Harbor or Traditional Plan

401(k) plans come in two basic types — traditional and safe harbor. Traditional plans are subject to annual ADP/ACP and top-heavy testing, while safe harbor plans automatically pass those tests by meeting certain contribution and participant disclosure requirements.

Safe harbor plans are the most popular with small businesses, which often struggle with those tests. They come in two sub-types — classic and Qualified Automatic Contribution Arrangements (QACAs). A QACA includes an automatic enrollment feature.

Before you start choosing features, choose a traditional or safe harbor plan as your base. That choice will dictate your plan's cost, design options, and annual administration responsibilities. Our comparison of safe harbor and traditional plans goes deeper; here is the short version.

Step #3 – Choose Your Employee and Employer Contributions

Now you can start picking the features of your 401(k) plan, beginning with contributions. They determine what your plan costs and how much you and your employees can save.

Employee Contributions

These contributions are deducted from employee wages based on a deferral election, which can be a dollar amount or a percentage of pay. There are four types to consider:

• • Elective deferrals – pre-tax contributions, which every 401(k) plan permits. They are subject to the IRC Section 402(g) limit — $24,500 for 2026 — and reduce the participant's taxable income now in exchange for tax on withdrawal.
  • Roth contributions – subject to the same 402(g) limit and distribution rules as pre-tax elective deferrals, only taxed when made. Roth contributions can be withdrawn tax-free, and their earnings can be withdrawn tax-free when certain conditions are met.
  • Catch-up contributions – an additional amount participants age 50 and older can defer beyond the 402(g) limit: $8,000 for 2026, or $11,250 at ages 60 through 63. Beginning in 2026, participants whose prior-year FICA wages from your company exceeded $150,000 must make their catch-ups on a Roth basis — so without a Roth feature, those employees cannot make them at all.
  • Voluntary contributions – after-tax contributions like Roth contributions, but far less common. The reason is their ACP test requirement, which makes them a poor fit for most 401(k) plans except solo (owner-only) plans.

Automatic Enrollment

Automatic enrollment enrolls eligible employees at a default deferral percentage unless they affirmatively elect a different rate, including zero. It is a reliable way to increase employee contributions, and you have three options:

• • Automatic Contribution Arrangement (ACA) – the most basic type. The plan document specifies the default deferral percentage that will be automatically deducted from wages.
  • Eligible Automatic Contribution Arrangement (EACA) – the default deferral percentage must be uniform, and an annual notice describing the feature must be distributed to plan participants. Participants may be allowed to withdraw automatic contributions, including earnings, within 90 days.
  • Qualified Automatic Contribution Arrangement (QACA) – a type of safe harbor 401(k) plan. The default deferral rate must start at no less than 3% and increase at least 1% annually to no less than 6%. It can be as high as 10% for the initial year and 15% for later years.

SECURE 2.0 requires most 401(k) plans established on or after December 29, 2022 to automatically enroll employees at 3% to 10% of compensation, escalating at least 1% per year to at least 10% (15% maximum). Businesses with 10 or fewer employees and businesses in existence less than three years are exempt.

If the mandate reaches your plan, your only choices are which arrangement to use and what default rate to set. If your plan is exempt, weigh the feature carefully — it adds administrative complexity, especially with an annual escalator, and the automatic deferral can upset surprised employees. Skipping it is reasonable when employee participation will not be a problem.

Employer Contributions

Employer contributions come in two basic types:

• • Matching contributions – go only to participants who make elective deferrals, in proportion to what they defer. The match formula sets the rate and the deferral percentage it applies to.
  • Nonelective contributions – go to every eligible participant, whether or not they defer. A profit sharing contribution is a familiar example.

Either type can be required or discretionary. A traditional plan requires no employer contribution at all, so anything you add is discretionary. A safe harbor plan requires one contribution — a match or a nonelective — and anything beyond it is discretionary.

Safe Harbor Contributions

If you chose a safe harbor plan, this is the contribution that buys your exemption from ADP/ACP testing, and your first decision is which of the two types to make. The formulas are in the Step #2 table; here is how to pick between them:

Discretionary Contributions

You can add a discretionary match, a profit sharing contribution, both, or neither. Profit sharing is the most flexible employer contribution there is — you decide the amount each year, including zero, and allocate it pro rata, integrated, or by new comparability — the formula to use when maximizing owner contributions is the goal.

Either contribution can also carry allocation conditions — requirements a participant must satisfy to receive the contribution for a year. There are two:

• • Last day rule – the participant must be employed on the last day of the plan year.
  • Hours requirement – the participant must work a minimum number of hours during the plan year, up to 1,000.

Conditions are one of two controls over what a discretionary contribution actually costs you. They cut the cost in a business with turnover, and they cut the goodwill the contribution buys, so use them deliberately.

Vesting Rules for Employer Contributions

A vesting schedule decides how much of their employer contributions participants take with them when they leave. Anything unvested is forfeited back to the plan. Employee money is never scheduled — elective deferrals, Roth and voluntary contributions, and rollovers are always 100% vested. What you can schedule depends on which employer contribution you are considering.

Safe harbor contributions. The rule turns on your sub-type:

• • Classic safe harbor – 100% immediate vesting, no schedule of any kind.
  • QACA safe harbor – up to a two-year cliff: nothing until two years of service, then 100%.

That two-year cliff, together with the lower match requirement, is a large part of why an employer picks a QACA over a classic safe harbor plan.

Discretionary contributions. A discretionary match or profit sharing contribution can carry a schedule, and the law sets two outer limits:

• • Three-year cliff – nothing until three years of service, then 100%.
  • Six-year graded – 20% after two years, rising 20% a year to 100% after six.

You can always vest faster than either schedule, and one rule overrides whatever you choose: participants become 100% vested at your plan's normal retirement age regardless of service, so a low retirement age shortens every schedule you set.

Whether a schedule is worth using comes down to turnover. With regular departures before the cliff, forfeitures meaningfully reduce what your contributions cost — you can use them to pay plan expenses, offset future contributions, or reallocate them to remaining participants. With a small, long-tenured staff, almost everyone vests anyway and the schedule buys you little. Immediate vesting is also a benefit worth advertising to new hires.

Roth Employer Contributions

SECURE 2.0 added an option worth knowing about: your plan can let participants designate any employer contribution as Roth — matching or nonelective, required safe harbor or discretionary. Offering the feature is your decision; using it is each participant's. Roth matching and nonelective contributions come with rules that catch sponsors out, so read them before you add the feature:

• • The participant elects it – you can make the option available, but you cannot designate a contribution as Roth on an employee's behalf.
  • It must be fully vested – only a contribution that is 100% vested when made can be designated Roth, so contributions on a vesting schedule are not eligible until the participant is fully vested.
  • It is taxable in the year contributed – the participant picks up the amount as income then rather than at distribution, and it is reported on Form 1099-R, not Form W-2.
  • Nothing is withheld – the contribution is not wages, so no income tax withholding or FICA applies. Participants who elect it may need to cover the tax another way.

Step #4 – Define Plan Compensation

All 401(k) plans must define the compensation that will be used to allocate contributions to plan participants. It sounds like a technicality, but the wrong definition is the most common operational error the IRS finds in 401(k) plans, and correcting it means funding missed contributions plus earnings out of pocket. Start from one of three definitions:

• • W-2 wages – compensation reported in Box 1 of Form W-2. Most employers start here because it is the easiest figure to pull, then add back pre-tax deferrals.
  • 3401(a) wages – compensation subject to federal income tax withholding.
  • 415 safe harbor – Form W-2, Box 1 wages plus the pre-tax deferrals and other salary reductions Box 1 leaves out. It gets you to pay before those reductions without a separate add-back.

You can exclude forms of compensation, but the exclusions cannot discriminate against non-HCEs. Stay within the 414(s) safe harbor exclusions and you avoid testing your definition every year:

• • Pre-entry compensation – pay earned by employees before they become plan-eligible.
  • Certain fringe benefits – including reimbursements and other expense allowances, cash and noncash fringe benefits, moving expenses, deferred compensation, and welfare benefits.
  • HCE compensation – any portion of compensation paid to Highly-Compensated Employees can be excluded.

Compensation for the Self-Employed

Whatever you choose for your employees, plan compensation for self-employed individuals — business owners taxed as a sole proprietor or partner — is earned income. Start from IRS Form 1065 Schedule K-1, Line 14(a) for partners or Form 1040, Schedule C, Line 31 for sole proprietors, then subtract deductions for Section 179 expenses and contributions made to employees.

S-corporation shareholders are the exception. Company profits flow through to them for tax purposes, much as they do in an unincorporated business, so a shareholder-employee can receive both W-2 wages and K-1 income. Only the W-2 wages count as plan compensation. The K-1 income does not.

Step #5 – Define Employee Eligibility

Your plan's eligibility requirements dictate when your employees can enter the plan. You can let them in immediately or require them to meet minimum age and service conditions first. The maximum age and service conditions your plan can require are:

• • Elective deferrals and safe harbor contributions – age 21 and 1 year of service.
  • Other contributions – age 21 and 2 years of service. If the service requirement is greater than 1 year, those employer contributions must be 100% immediately vested.

You have two options for crediting employee service for plan eligibility purposes:

• • Elapsed time – the easiest method for crediting service. Only employment dates matter; hours worked are irrelevant.
  • Counting hours – employees must work a specified number of hours during an Eligibility Computation Period (ECP). An ECP cannot be more than 12 months long or require more than 1,000 hours of service. An employee's initial ECP commences on their hire date.

Once an employee has met your plan's minimum age and service conditions, you must let them in on the next entry date, which you also define. Your options are immediate, monthly, quarterly, and semi-annual. You can also exclude certain employees from plan participation altogether — union employees, nonresident aliens, leased employees, or a defined job class — as long as annual coverage testing can pass.

The practical trade-off: employers with high turnover generally use the maximum age and service conditions to keep short-tenure employees out of the plan. Employers competing for talent use minimal requirements and accept the higher participant count. In a traditional plan, be careful — restrictive eligibility and an ADP test problem often show up together.

Long-Term, Part-Time (LTPT) Employee Rules

A long-term, part-time (LTPT) employee is a part-time worker who must be allowed to participate in a 401(k) plan even if they never meet the plan's standard eligibility requirements. Under current law, an employee is considered LTPT if they work at least 500 hours in two consecutive 12-month periods.

Plans may apply different rules to LTPT employees than to other participants:

• • Must be allowed to make elective deferrals.
  • May be excluded from employer contributions until they satisfy the plan's standard eligibility requirements.
  • May be excluded from certain nondiscrimination and top-heavy testing requirements.
  • Special vesting rules may apply once they become eligible for employer contributions.

Administering LTPT rules can be complex, particularly due to additional tracking and testing considerations. You can avoid the rules altogether by using the elapsed time method for counting employee service.

Step #6 – Choose Your Distribution and Loan Options

At this point you have determined the rules for getting money into your 401(k) plan. Now you must determine the rules for getting money out. A 401(k) account withdrawal is called a distribution, and there are two basic types — post-termination and in-service. To give plan participants even greater access to their account, you can add a participant loan feature. Our 401(k) distribution rules FAQ covers the mechanics in detail.

Post-Termination Distributions

These distributions are made to participants who have terminated employment. Many 401(k) plans permit only a lump sum distribution option, but you can also allow partial or installment payments.

You can add an involuntary distribution provision to force out small account balances. Balances of $1,000 or less may be distributed in cash without participant consent, and balances above $1,000 and up to $7,000 must be automatically rolled into an IRA for the participant. SECURE 2.0 raised that upper threshold from $5,000, and using it is one of the easiest ways to keep terminated participants — and the per-participant fees and missing-participant searches that follow them — off your books.

In-Service Distributions

These distributions are made to participants who are still employed. You have no obligation to offer in-service distribution options, but plan participants tend to appreciate their availability. Your options are subject to the following limitations:

• • Elective deferrals (including Roth), safe harbor contributions, QNECs, and QMACs cannot be distributed until age 59½.
  • Discretionary matching and profit sharing contributions can be distributed at any age.
  • Employee rollover and voluntary contributions can be distributed at any time.
  • Hardship distributions can be allowed at any time, for the events the IRS defines.

Two tax points are worth explaining to participants before you add these options. An in-service distribution is taxable income in the year received unless it is rolled over, and one that is eligible for rollover carries 20% mandatory federal withholding when it is paid to the participant instead. A hardship distribution cannot be rolled over, so that 20% rule does not apply to it — but a 10% early distribution penalty can, for participants under age 59½.

SECURE 2.0 added several optional penalty-free withdrawal types worth considering: emergency personal expense distributions of up to $1,000 per year, domestic abuse victim distributions, terminal illness distributions, qualified disaster recovery distributions, and pension-linked emergency savings accounts. Each adds a little administration, so add the ones your workforce will actually use. Required minimum distributions are not a design choice — they apply by law — but your plan document has to address them.

Participant Loans

Your plan can allow or prohibit participant loans. Loans are often very popular with employees, but the feature adds administrative complexity for you: approving requests, setting up and maintaining payroll deductions, tracking repayments, and reporting a deemed distribution when a participant defaults — which happens most often after someone terminates employment. You should understand the participant loan rules before you add the feature to your plan.

If your reason for offering loans is emergency access, consider whether hardship distributions or the new emergency personal expense withdrawals accomplish the same thing with less work. If you do allow loans, limiting participants to one outstanding loan at a time keeps the burden manageable. Our post on design choices that simplify annual administration covers this and other decisions that quietly add work.

Your 401(k) Plan Design Checklist

Here is every decision from the six steps in one place, grouped by step. Where traditional and safe harbor plans differ, the options sit side by side; where they work the same way, one entry spans both columns. Mark your selections and give the result to your 401(k) provider — that is all they need to draft a plan document that matches your goals.

Curious how your choices compare? Our latest 401(k) plan design study reports what thousands of small business plans actually do.

Expert 401(k) Plan Design Can Save You Thousands

401(k) plans are highly customizable. They can be tailored to meet very different employer goals — maximizing business owner contributions, incentivizing elective deferrals, or providing a minimum retirement benefit to low-wage workers. Matching your goals to the options available is the whole point of plan design.

Unfortunately, not all 401(k) providers offer consultative plan design. Instead, they limit an employer's options to a handful of cookie-cutter designs. That can seem convenient, but it is often meant to steer clients toward basic designs that are easy for the provider to administer — one of several 401(k) conflicts of interest worth watching for.

Do not fall for it. Choosing the wrong plan design can cost an employer thousands of dollars in unnecessary contributions, or hours of avoidable administration, every year. A plan design expert can lead the process in 30 minutes or less, and that half hour can make or break a plan's success. You should settle for no less.