IRS

New Guidance on Automatic Enrollment

in 401(k) Plans

Over the past 30 years, there hasbeen a dramatic shift away fromdefined benefit plans. Now mostemployees save for retirement byparticipating in a defined contri-bution plan, such as an InternalRevenue Code (IRC) Section401(k) plan, in which theemployee is responsible fordeciding whether to participate,how much to contribute, andhow the contributions will beallocated among investmentalternatives. Many employeesfaced with these complicateddecisions have decided to simplyavoid them by not participatingin the retirement savings plansavailable to them. Congressattempted to address this partici-pation problem by enacting auto-matic enrollment provisions aspart of the Pension ProtectionAct of 2006. Automatic enroll-ment provisions require employ-ees to “opt out” if they do notwant to participate, rather thanthe more common “opt in”approach. These rules apply notonly to new hires, but can alsobe used to automatically enrollemployees who are now eligibleto participate but have notelected to do so.

In November 2007, the IRSissued proposed regulations pro-

viding guidance for employerswho want to adopt these auto-matic enrollment provisions fortheir 401(k) plans. These newregulations explain the specialnondiscrimination safe harborprovision for qualified automaticcontribution arrangements(QACAs) and the new permissi-ble withdrawal rules allowing anemployee who has been auto-matically enrolled to opt out andwithdraw contributions madeduring the first 90 days. The reg-ulations also include guidanceon corrective distributions.These regulations are effectivefor plan years beginning on orafter January 1, 2008.

BACKGROUND

IRC Section 401(k) plans,also known as cash or deferredarrangements, allow employeesto choose between receiving acertain amount in cash or havingthe employer pay that amount onthe employee’s behalf into aqualified trust or providing abenefit under a plan deferringthe receipt of compensation.Contributions made at the elec-tion of an employee are com-monly known as elective defer-rals, but are also referred to as

pretax elective contributionsbecause they are not includiblein income when contributed.Any income tax on contributionsand earnings is deferred untildistributed to the employee.

In a typical 401(k) plan,employers require employees toenroll in the plan by making anaffirmative contribution electionto participate in the plan. Someemployees, however, delay mak-ing that contribution electionsometimes because they thinkthe investment choices are toocomplex or simply because ofprocrastination. Historically,most employers have designedtheir plans so that an employeewho takes no action is treated aselecting to not participate in theplan. However, using no electionas the default not only canimpact the employee’s ability toadequately save for retirement,but if there is a high degree ofnonparticipation among non-highly compensated employees(NHCEs), it can prevent thenondiscrimination tests frombeing passed and reduce thebenefit that highly compensatedexecutives can get from the plan.

Under the actual deferral per-centage (ADP) nondiscriminationtest, the average percentage of

Shirley Dennis-Escoffier

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compensation deferred for highlycompensated employees (HCEs)is compared annually to the aver-age percentage of compensationdeferred for NHCEs eligibleunder the plan. A similar actualcontributions percentage (ACP)test applies to matching contribu-tions. If certain limits areexceeded by the HCEs, correctiveaction must be taken, such asreturning contributions to HCEsthrough corrective distributions.

To address these concerns,some businesses have modifiedtheir 401(k) plans by implement-ing automatic enrollment proce-dures in which the default ischanged so that employees whotake no action are automaticallyenrolled in the plan. Under thisnegative election arrangement,an employee is deemed to havemade a 401(k) contribution elec-tion at a certain contribution rateunless the employee opts out.

Since the late 1990s, the IRShad indicated its approval ofautomatic enrollment features,through a series of revenue rul-ings and similar pronounce-ments, as long as the employeewas given the opportunity to optout of the plan and was providedwith initial and annual noticesdescribing the employee’s rightto revoke the salary deferral.Most businesses, however,remained hesitant to implementautomatic enrollment for threeprincipal reasons.

First, many states restrictedan employer’s ability to deductamounts from an employee’spaycheck without the employee’swritten consent, so an opt-outnegative election for participa-tion in a 401(k) plan could havepotentially violated state law.Second, businesses were con-cerned they could face potentialfiduciary liability associatedwith choosing the investmentoptions for automatically

enrolled funds. To minimize thispotential fiduciary liability, thebusinesses that did use opt-outplans typically designated amoney market fund as thedefault fund for automatic con-tributions. Finally, many busi-nesses were concerned about theadministrative burdens associ-ated with employees who areautomatically enrolled and optout after a short participationperiod. This would leave theemployer with the burden ofmaintaining small account bal-ances, while employees couldnot get the money back (exceptunder special circumstances suchas hardship or severance ofemployment) because the fundswould be considered part of theplan assets.

PENSION PROTECTION ACT

Congress attempted toaddresses these concernsthrough the Pension ProtectionAct of 2006 (PPA) by removingthe legal and administrative bar-riers associated with implement-ing automatic enrollment fea-tures in Section 401(k) plans, aswell as similar features in Sec-tion 403(b) tax-shelter annuitiesand Section 457(b) governmentaldeferred compensation plans.First, the PPA addressed con-cerns that state laws might hin-der automatic enrollment by pro-viding that all state laws thatprohibit automatic enrollmentare preempted by federal law.

Next, the PPA relieved busi-nesses of fiduciary responsibilityfor deferrals invested in a quali-fied default investment alterna-tive (QDIA). Following the law’spassage, the Department ofLabor issued regulations permit-ting employers to automaticallyenroll workers into balancedfunds, which invest in bothstocks and bonds, or in target-

date retirement funds. Addition-ally, the Labor Department’s reg-ulations also say employers canease workers into automaticenrollment by putting them in amoney market account for thefirst 120 days and clarify thatemployers that have previouslyput automatic enrollment contri-butions in money market or sta-ble value funds would not besubject to legal liability.

Employees must be providedwith a notice that describes theirright to revoke the election andexplains how the deferrals willbe invested if the employee doesnot specify an investment. Thenotice must be provided within areasonable period of time beforeeach plan year and must providethe employee with a reasonableperiod of time to take action.Thus, businesses are not liablefor losses that result from invest-ing an employee’s defaultaccount if the default fund meetsthe investment guidelines issuedby the Department of Labor andthe plan provides employeeswith the required notice.

Finally, to resolve theadministrative concerns relatedto the maintenance of low bal-ance accounts, the PPA allowsparticipants to withdraw auto-matic enrollment contributions ifthey opt out within 90 days ofthe first automatic deferral. ThePPA also allows automaticenrollment plans a longer timeperiod (up to six months) afterthe end of the plan year to returnexcess deferrals to HCEs (com-pared to the previous time limitof two-and-a-half months). Inaddition, the PPA creates a newsafe harbor called a qualifiedautomatic contribution arrange-ment (QACA) that would allowplans to automatically pass thenondiscrimination tests.

In November 2007, the IRSissued proposed regulations

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explaining how the automaticenrollment arrangements applyto IRC Section 401(k) plans,Section 403(b) tax-shelteredannuities, and Section 457(b)governmental plans. The regula-tions address the QACA and theability of an employee to opt outand request a distribution of thecontributions made during thefirst 90 days of the arrangement,and include guidance on correc-tive distributions. The regula-tions are effective for plan yearsbeginning on or after January 1,2008, and may be relied uponpending the issuance of finalregulations. If the final regula-tions are more restrictive thanthese provisions, then they willbe applied prospectively only.

QUALIFIED AUTOMATICCONTRIBUTIONARRANGEMENTS

A QACA will be deemed tosatisfy the nondiscriminationtests that are intended to prohibitkey employees and owners fromdisproportionately benefitingfrom the plans. To take advan-tage of this safe harbor, the planmust automatically enroll allparticipants who have not madea written election in the past toparticipate or not to participateand also meet certain contribu-tion percentages and vestingrequirements.

Contribution Percentages

A QACA must have a sched-ule of automatic contributionpercentages, stated as a percent-age of an employee’s compensa-tion. The contribution percent-ages must be within a range thatcannot be less than 3 percent andcannot exceed 10 percent, andthese percentages must applyuniformly to all eligible employ-ees. The bottom of the range

varies depending on how longthe employee has been enrolledin the plan. For the initial period,which begins when the employeefirst participates in the QACAand ends on the last day of thefollowing plan year (so this ini-tial period could last two planyears), the automatic contribu-tion percentage cannot be lessthan 3 percent. For the next threeyears, the minimum contributionpercentage increases in 1 percentincrements each year, until itreaches 6 percent. The minimumemployee contribution percent-age then remains at 6 percent forall future years. The new pro-posed regulations clarify thatthese contribution percentagesare minimums and that a QACAcan have higher percentages (notmore than 10 percent). Addition-ally, the QACA will not fail theuniformity requirement if:

• The elective deferral per-centage varies based on thenumber of years an eligibleemployee has participated inthe plan;

• The rate of the participant’sprior election (already ineffect when the QACAbecomes effective) is notreduced;

• The amount of elective con-tribution is limited so as notto exceed the limits on com-pensation (under Section410(a)(17)), elective defer-rals (under Section 402(g)),or benefits and compensa-tion (under Section 415); or

• The plan suspends anemployee from making elec-tive deferrals for six monthsfollowing a hardship distri-bution (as long as after thesuspension the employeewill resume the percentageschedule at the same level asif the suspension had notapplied).

The proposed regulationsprovide that the default electionceases to apply to any eligibleemployee if the employee makesan affirmative election to havecontributions made at a certainlevel. Thus, an employee canmake an affirmative election thatwill be honored in subsequentplan years that changes the con-tribution percentage, or thatcompletely stops contributions.

Current employees who wereeligible to participate and whohad an election in effect on theeffective date of the QACA areexcluded from the default rule,as long as the employee com-pleted an election form andchose an amount or percentage(even if the amount was zero) ofcompensation to be deferred.

Employer Contributions and Vesting

The proposed regulationsprovide that employers canchoose between making amatching contribution or a non-elective contribution on behalfof each NHCE. If the employerchooses to make matching con-tributions, the match must equal100 percent of the first 1 percentan employee contributes andthen match an additional 50 per-cent of the employee’s electivecontributions between 1 and 6percent. If the employer choosesto make nonelective contribu-tions (not based on theemployee’s elective deferral con-tributions), they must equal atleast 3 percent of the employee’scompensation. In addition, theQACA’s vesting schedule can beslower for both matching andnonelective safe harbor contribu-tions (two years, rather thanimmediately).

If all of these requirementsare met, the plan is deemed to sat-isfy the ADP nondiscrimination

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test for the employee’s electivedeferral contribution. If theemployer chooses to make match-ing contributions, the plan willalso be deemed to satisfy the ACPnondiscrimination test for thematching contributions, as long asthe following additional require-ments are met:

• Matching contributions arenot provided for electivedeferrals in excess of 6 per-cent of compensation;

• The rate of matching contri-butions does not increase asthe rate of an employee’selective deferrals increases;and

• Matching contribution ratesfor HCEs do not exceed therates for NHCEs.

Notice and TimingRequirements

Each eligible employeeunder a QACA must receive anotice within a reasonable periodbefore each plan year. The pro-posed regulations state that thenotice must provide the informa-tion that normally must be pro-vided with a safe harbor notice,plus it must explain:

• The employee’s right tochoose not to have electivecontributions made on theemployee’s behalf or to electto have contributions madein a different amount or per-centage; and

• How contributions madeunder the automatic contri-butions arrangement will beinvested if the employeedoes not make an investmentdecision.

The explanation cannot be madeby reference to plan documents.

The proposed regulationsstate that plans will satisfy the

timing requirement to providenotices within a reasonableperiod by furnishing the noticeto participants at least 30 days(and no more than 90 days)before the beginning of eachplan year. In addition, in the caseof an employee who does notreceive the notice within thisperiod because the employeebecomes eligible after the 90thday before the beginning of theplan year, the timing require-ment is considered satisfied ifthe notice is provided no morethan 90 days before theemployee becomes eligible (andno later than the date theemployee becomes eligible).

Permissible Withdrawals

To encourage automaticenrollment, Congress providedrelief from distribution require-ments for contributions madeunder automatic enrollment byallowing employers the option ofreturning default elective defer-rals as permissible withdrawals.The proposed regulations allowthe return of amounts requestedby an employee within 90 daysof the first elective deferrals.The 90-day window begins onthe date the amounts would havebeen includible in the employee’sgross income if they had notbeen contributed to the plan.

The proposed regulationsstate that the distribution is theemployee’s account balanceattributable to the default elec-tive deferrals, adjusted for gainsand losses. The distribution maybe reduced for generally applica-ble fees, although a plan may notcharge a different fee for thisdistribution than would apply toother distributions. The distribu-tions are treated as taxableincome in the year distributed(and reported on Form 1099-R),but are not subject to the 10 per-

cent early withdrawal penalty taxand are not eligible for rollovertreatment.

If elective deferrals are with-drawn, employees will also for-feit any employer matching con-tributions associated with thewithdrawn amounts. The pro-posed regulations state that theforfeited matching contributionis not a mistaken contribution orother erroneous contribution soit cannot be returned to theemployer or distributed to theemployee. Any employer match-ing contributions that are for-feited must remain in the planand be treated as any other planforfeitures.

The proposed regulationsstate that a business is notrequired to offer a permissiblewithdrawal feature in its planand if it chooses to do so, thebusiness does not have to offerthis withdrawal feature to all eli-gible employees. For example,an employer could limit thiswithdrawal option to onlyemployees who made no previ-ous elective contributions to the401(k) plan. The proposed regu-lations state that a business maynot prohibit an employee frommaking any future elective con-tributions after making a permis-sible withdrawal; however, thebusiness may specify, in thewithdrawal election form, adefault election under whichelective contributions would stopunless the employee makes anaffirmative election.

The proposed regulationsalso address corrective distribu-tions, which permit a plan to dis-tribute excess contributions toparticipants to avoid the imposi-tion of the 10 percent excise tax.Plans will now have six months(rather than two-and-a-halfmonths) after the close of theplan year in which the contribu-tions were made to complete the

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corrective distributions. Addi-tionally, corrective distributionsno longer need to include incomeallocated to the period after theend of the plan year (referred toas gap period income). Thesecorrective distributions areincluded in the employee’s grossincome for the tax year in whichthey are distributed.

RECOMMENDATIONS

Employers should considerthe advantages and disadvan-tages of adding automaticenrollment if they do notalready have it. Good candi-dates for adopting the auto-matic enrollment feature arecompanies that have low partic-ipation rates and/or low defer-ral rates and low turnover.Businesses whose executiveshave had some of their contri-butions returned will be pleasedthat the QACA safe harborrules allow highly compensatedemployees to maximize theircontributions without beingpenalized, even if NHCEs donot want to contribute.

Although automatic enroll-ment has many advantages, busi-nesses should be aware of severaladministrative issues. Automaticenrollment may increase the cost

of the plan because with greaterparticipation comes a greaternumber of employee accounts. Inaddition, if the plan provides formatching contributions, auto-matic enrollment may increasethe total amount of matchingcontributions paid by theemployer each year.

Companies should talk totheir plan administrator regard-ing the requirements and impli-cations of plan changes. Busi-nesses that decide to moveforward need to develop animplementation plan, including acommunication campaign toeducate their employees aboutthe automatic enrollment fea-tures. Employees need to bemade aware that:

• They are enrolled, that theircontributions are on a tax-deferred basis, and the regu-lations of IRC Section401(k) plans apply.

• They can opt out at any timewithin 90 days of beingautomatically enrolled.

• They can change their auto-matic deferral rate anddefault investment choices.

• The funds have beeninvested for them, but it istheir responsibility to deter-mine whether the investment

choices are appropriate forthem based on their risk tol-erance, time horizon, desiredretirement income level, cur-rent and future financial sit-uations, and investment pref-erences. They should alsoreview materials that areprovided to them, includingenrollment kits, informationon the employer’s Web site,information on the provider’sWeb site, and any correspon-dence sent to them regardingtheir retirement accounts.

For more information, busi-nesses may wish to visit a Website (www.RetirementMadeSimpler.org) developed by acoalition of advocacy, regulatory,and policy organizations. Thegoal of this coalition is toencourage more Americans tosave for a secure retirement byproviding companies with thetools and information they needto add automatic features to their401(k) plans. This Web site isparticularly useful to small andmedium-sized employers andincludes information about auto-matic 401(k) plans, why theywork, best practices on how toimplement them, and experi-ences of companies that havealready adopted these plans.

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Shirley Dennis-Escoffier, PhD, CPA, is an associate professor of accounting at the University of Miami,Coral Gables, Florida. She is a past president of the American Taxation Association and has publishednumerous articles in tax journals.

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