Do you want to offer a retirement plan that provides a high level of employee participation and makes it easy for you to withhold employee contributions and select the investments for those contributions? Do you currently have a plan that fails to meet its annual non-discrimination testing requirements? If so, then you may want to consider an automatic enrollment feature for your 401(k) plan.
Approximately 30 percent of eligible employees do not participate in their employer's 401(k) plan. Many employees are intimidated by their employer’s 401(k) plan and all the decisions (contributions, investments, etc.) needed to participate. Whether you already have a 401(k) plan or are considering one, an automatic enrollment feature offers the following advantages:
- Increased plan participation
- Allows for the certain investments if employees do not select their investments
- Simplifies the selection of investments appropriate for long-term savings for participants
- Helps employees begin saving for their future
- Offers significant tax advantages (including deduction of employer contributions and deferred taxation on contributions and earnings until distribution)
- Permits distributions to employees who opt out of participation in the plan within the first 90 days
A basic automatic enrollment 401(k) plan must state that employees will be automatically enrolled in the plan, unless they elect otherwise, and must specify the percentage of an employee's wages that will be automatically deducted from each paycheck for contribution to the plan. The document must explain that employees have the right to elect not to have salary deferrals withheld or to elect a different percentage to be withheld.
An eligible automatic contribution arrangement (EACA) is similar to the basic automatic enrollment plan, but has specific notice requirements. An EACA can allow automatically enrolled participants to withdraw their contributions within 30 to 90 days of the first contribution.
A qualified automatic contribution arrangement (QACA) is a type of automatic enrollment 401(k) plan that automatically passes certain kinds of annual required testing. The plan must include certain required features, such as a fixed schedule of automatic employee contributions, employer contributions, a special vesting schedule, and specific notice requirements.
Employers must notify employees who are eligible to participate in the plan about certain benefits, rights and features. Employees must receive an initial notice prior to automatic enrollment in the plan and receive a similar notice annually.
The notice should include information about the automatic contribution process, including the opportunity to elect out of the plan. In addition, the notice must describe the default investment used by the plan, the participants' right to change investments, and where to obtain information about other investments offered by the plan.
An annual notice must be provided to participants and all eligible employees at least 30 days, but not more than 90 days, prior to the beginning of each subsequent plan year.
If the participant, after receiving the initial or annual notice, does not provide investment direction, the participant is considered to have decided to remain in a default investment.
Employees are automatically enrolled in the plan and a specific percentage will be deducted from each participant's salary unless the participant opts out or chooses a different percentage.
Basic and Eligible Automatic Enrollment 401(k) Plans – As with any 401(k) plan, in addition to employee contributions, you decide on your business' contribution (if any) to participants' accounts in your plan. If employers decide to make contributions to an automatic enrollment 401(k) plan for employees, there are additional options. Employers can match the amount their employees decide to contribute (within certain limits), or contribute a percentage of each employee's compensation (called a nonelective contribution) – or both. Employers have the flexibility of changing the amount of matching and nonelective contributions each year, according to business conditions.
Qualified Automatic Contribution Arrangements – If a plan is set up as a QACA with certain minimum levels of employee and employer contributions, it is exempt from the annual testing requirement that applies to a traditional 401(k) plan. The initial automatic employee contribution must be at least three percent of compensation. Contributions may have to automatically increase so that, by the fifth year, the automatic employee contribution is at least six percent of compensation.
The automatic employee contributions cannot exceed 10 percent of compensation in any year. The employee is permitted to change the amount of his or her employee contributions or choose not to contribute, but must do so by making an affirmative election.
The employer must at least 1) make a matching contribution of 100 percent for salary deferrals up to one percent of compensation and a 50 percent match for all salary deferrals above one percent, but no more than six percent of compensation; or 2) make a nonelective contribution of three percent of compensation to all participants.
Contribution Limits – Employees can make salary deferrals of up to $17,000 for 2012. This includes both pre-tax employee salary deferrals and after-tax designated Roth contributions (if permitted by the plan). An automatic enrollment 401(k) plan can allow catch-up contributions of $5,500 per year for 2012 for employees age 50 and over.
Automatic employee contributions are immediately 100 percent vested.
Employer contributions are vested according to the plan's vesting schedule. However, the required employer contributions under a QACA must be fully vested by the time an employee has completed two years of service.
Basic automatic enrollment 401(k) plans and most EACAs are subject to annual testing to ensure the amount of contributions made on behalf of rank-and-file employees is proportional to contributions made on behalf of owners and managers. Automatic enrollment typically increases participation, thereby making it more likely that a plan will pass the test. Automatic enrollment 401(k) plans set up as QACAs are not subject to this annual testing.
Investing the Contributions
You can automatically invest employee contributions in certain default investments that generally offer high rates of return over the long term and provide a greater opportunity for employees to save enough money to take them through retirement. If carried out properly, employers can limit liability as plan fiduciary for any automatic enrollment 401(k) plan losses that are a result of investing participants' contributions in these default investments. Note that employers are still responsible for prudently selecting and closely monitoring these default investments. There are conditions to obtain this relief from liability:
- Plan sponsors place the participant's contributions in certain types of investments.
- Before his or her first contribution is deposited, the participant receives a notice describing the automatic enrollment process; a similar notice is sent annually thereafter.
- The participant does not provide investment direction.
- The plan passes along to the participant material related to the investment.
- The participant is given the opportunity periodically to direct his or her investments from the default investment to a broad range of other options.
Qualified Default Investment Alternatives – You can choose from four types of investment alternatives for employees' automatic contributions, called qualified default investment alternatives, or QDIAs. Three alternatives are diversified to minimize the risk of large losses and provide long-term growth. They are:
- A product with an investment mix that changes asset allocation and risk based on the employee's age, projected retirement date, or life expectancy (for example, a lifecycle fund);
- A product with an investment mix that takes into account a group of employees as a whole (for example, a balanced fund); and
- An investment management service that spreads contributions among plan options to provide an asset mix that takes into account the individual's age, projected retirement date or life expectancy (for example, a professionally managed account).
There is an alternative that allows plans to invest in capital preservation products, such as money market or stable value funds, but only for the first 120 days after the participant's first automatic contribution. This option can be used only in EACAs that permit employees to withdraw their automatic contributions and earnings between 30 and 90 days (as specified in the plan) after the participant's first automatic contribution. Before the end of the 120-day period, if you receive no direction, you must redirect the participant's contributions in the capital preservation product to one of the long-term investments mentioned above.
Note that you do not have to select a QDIA for your plan. You may find that other default investment alternatives would be more appropriate for your employees.
Distributing the Contributions
Employees may not want to participate in the company retirement plan. If employers want to allow participants to withdraw their contributions within 30 to 90 days of the first contribution, your plan document must provide for this option and be set up as an EACA. Any distributed amounts, including earnings, are treated as taxable income in the year distributed. The distribution is reported on a Form 1099-R and are not subject to the 10 percent early withdrawal tax.
If an employee decides to withdraw investments within 30 to 90 days of the first contribution, a plan cannot impose restrictions, fees or expenses beyond standard fees for services, such as investment management and account maintenance. Further, participants should not be subject to penalties, such as surrender charges, liquidation fees, or market value adjustments.
For questions regarding your retirement plan, please contact any of the members of our Employee Benefit Plan Services Group.