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April 8th, 2015

Should Your 401(k) Plan Adopt An Auto-Enrollment Feature?

Current tax law gives employers encouragement to start automatically enrolling employees for tax-saving 401(k) elective deferral contributions (also called salary reduction contributions). The Pension Protection Act of 2006 removed perceived state-law restrictions and made other changes.

The end result of these changes: Companies adopting auto-enrollment features will have more employees participating. Larger allowable salary reduction contributions can likely be made for higher-paid employees, because lower-paid workers will be contributing more.

An Example of the Rules in Action

In 2015, let’s say your company’s 401(k) plan installs an auto‑enrollment arrangement with escalating safe-harbor contribution percentages.
An employee named Ben does not opt out of the program. Let’s assume:

  • Ben’s 2015 salary is $50,000. For that year, three percent of his salary (or $1,500) will automatically be withheld and contributed to his 401(k) account.
  • For 2016, Ben’s salary is $53,000 and four percent (or $2,120) will automatically be contributed.
  • Ben’s salary increases to $58,000 in 2017. For that year, five percent will automatically go into his account, which amounts to $2,900.
  • In 2018, Ben gets another raise and now earns $60,000. For that year, six percent of his salary (or $3,600) is contributed.
  • For 2019 and later years, the plan calls for the same six percent automatic contribution rate.

The auto‑enrollment feature puts Ben’s retirement savings on cruise control and allows him to put away $10,120 over four years, not including investment earnings It also lowers his income tax bills.
Meanwhile, it makes it easy for your company to satisfy the nondiscrimination and top heavy rules that can otherwise make a 401(k) plan troublesome to operate.

That is because the Internal Revenue Code prohibits plans from discriminating in favor of highly compensated employees with respect to contributions or benefits.

Plans are tested for discrimination using a mathematical formula that measures contributions for highly compensated employees with those of other employees.

How Automatic Enrollment Works

Under a 401(k) auto-enrollment feature, employees must affirmatively opt out of making elective deferral (salary reduction) contributions. In other words, unless the employee takes action to opt out, contributions are automatically withheld from his or her salary.

Until now, many employers have followed the opposite policy of making employees affirmatively opt in for elective deferral contributions. In other words, contributions are withheld only when the employee specifically directs the employer to do so.

Under the Pension Protection Act, the removal of state-law restrictions on auto-enrollment arrangements is intended to reverse the playing field and cause more employees to participate in 401(k) plans. Congress passed the provision so that Americans would save more for retirement.

Rule Changes

The tax law includes two other important auto-enrollment changes that kicked in starting with plan years beginning in 2008.

1. A Window Period to Recover Unintended Contributions – The first change allows 401(k) plans to give employees a window period of up to 90 days after the auto-enrollment date to opt out of the program and get their money back. Of course, the amounts employees get back will be added back to their taxable wages.2. A Safe-Harbor Auto-Enrollment Contribution Formula – This encourages employers to install so-called safe-harbor automatic enrollment arrangements. These have escalating contribution percentages. For example, a plan with a safe-harbor feature could automatically withhold at least three percent of an employee’s salary for the first year, increasing to at least four percent for the second year, going up again to at least five percent for the third year, and then increasing to at least six percent for later years. (The percentage cannot exceed 10 percent for any year.)

The employer is required to match a portion of each employee’s auto‑enrollment contributions (according to another formula), and those employer matching contributions must be 100 percent vested after two years.

Key Point: A 401(k) plan that includes a safe-harbor auto-enrollment arrangement is deemed to accomplish the following:

  • It automatically satisfies the complicated nondiscrimination rules for employee elective deferral contributions and employer matching contributions.
  • It also fulfills the equally complex “top heavy” contribution rules, which measure the account values of “key employees” as compared with other employees in the plan. Therefore, a beneficial side effect of installing a safe-harbor auto-enrollment feature is that higher-paid employees can start making larger elective deferral contributions without causing the plan to violate the nondiscrimination and top heavy rules.

There are many advantages for employers in the new 401(k) plan auto-enrollment rules, which can be applied to new hires or all qualified employees.

Information courtesy of © 2015, Powered by Thomson Reuters Checkpoint
We provide the information in this e-newsletter for general guidance only. This does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.

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