On November 8, 2007, the Internal Revenue Service published proposed regulations relating to automatic contribution arrangements for defined contribution plans. In an effort to increase participation in tax-qualified retirement plans, the Pension Protection Act of 2006 created tax advantages to encourage defined contribution plans to enroll employees automatically unless the employees opt out of participation.
These rules provide a new nondiscrimination safe harbor for 401(k) plans with an automatic contribution arrangement. Further, the rules provide that participants who are automatically enrolled in a 401(k) plan, a 403(b) plan or a 457(b) plan can elect a refund of their contributions within 90 days of enrollment without being subject to early distribution penalties. Both of these features are available for plan years beginning on or after January 1, 2008. The proposed regulations describe the conditions for taking advantage of these features and may be immediately relied upon. If the final regulations are more restrictive, the more restrictive provisions will only be effective prospectively.
- New employees and current employees who have not previously made an affirmative deferral election may be subject to automatic enrollment and automatic increases under the automatic contribution safe harbor.
- The automatic contribution safe harbor permits a lower level of matching contributions than is permitted for other 401(k) plan safe harbors. Additionally, unlike other 401(k) plan safe harbors, employer matching or nonelective contributions do not have to be immediately fully vested.
- Participants in an eligible automatic contribution arrangement have a 90-day window beginning with their first elective contribution to request a refund of their prior deferrals. Any matching contributions on the refunded contributions will be forfeited.
- The Service coordinated the notice requirements with the Department of Labor so that a single notice may satisfy the notice requirements under the automatic contribution proposed regulations and under the Department of Labor’s final regulations for qualified default investment alternatives.
Qualified Automatic Contribution Arrangements (“QACA”)
Effective for plan years beginning on or after January 1, 2008, a 401(k) plan that implements a QACA will be deemed to satisfy certain nondiscrimination requirements under the Code. Under the Code, a 401(k) plan must pass the actual deferral percentage (“ADP”) test with respect to participant elective contributions and the actual contribution percentage (“ACP”) test with respect to employer matching contributions and employee after-tax contributions. A plan that incorporates a QACA will be deemed to have satisfied the ADP test and may be deemed to have satisfied the ACP test with respect to matching contributions if it satisfies additional criteria. As with other 401(k) plan safe harbors, amendments adopting the QACA safe harbor must be adopted before the first day of the plan year and remain in effect for the entire plan year.
Who is subject to automatic contributions?
Automatic contributions at a default rate must apply to new employees and to current employees who do not have an affirmative election in place to participate or not to participate in the plan. Generally, current employees who have not enrolled specifying a percentage of their compensation (including 0%) to defer under the plan do not have an affirmative election in place. As a result, current employees who have not enrolled in a plan or who were enrolled pursuant to an existing automatic contribution arrangement may be subject to automatic contributions at a default rate under a QACA.
Employees must have the opportunity to opt out of automatic contributions. An employee who makes an affirmative election not to contribute or to contribute at a different rate will not be subject to automatic contributions at a default rate as long as the affirmative election remains in place.
When does automatic enrollment occur?
If an employee does not opt out or otherwise make an affirmative election, the employee must be enrolled and deemed to make elective contributions at a default contribution rate on the later of the first day of the plan year or the date on which the employee becomes eligible to participate under the terms of the plan.
What are the default rates for elective contributions?
An employee who does not have an affirmative election in place must be treated as electing to defer compensation at a default contribution rate that is at least equal to a “qualified percentage.” A qualified percentage cannot exceed 10% and must satisfy the minimum percentage requirements for each period the participant has been enrolled in the automatic contribution arrangement, as follows:
- Initial period. The minimum percentage is 3%. This period begins the day the participant first participates in the automatic contribution arrangement and ends on the last day of the following plan year. For example, for an employee who is automatically enrolled in a calendar year plan on January 1, 2008, the initial period ends on December 31, 2009.
- Second year. The minimum percentage is 4%.
- Third year. The minimum percentage is 5%.
- Later years. The minimum percentage is 6%.
In addition, a qualified percentage must be uniform for all employees, subject to the following exceptions:
- The default contribution rate may vary according to the number of years an employee has participated in the automatic contribution arrangement.
- The default contribution rate must not apply if it would reduce a participant’s existing contribution rate.
- The default contribution rate may not result in an employee exceeding the Code’s contribution limits.
- A participant’s default contributions may be suspended upon taking a hardship distribution from the plan.
What are the requirements for employer contributions?
The plan must provide for either matching contributions or nonelective contributions on behalf of non-highly compensated employees as follows:
- Matching contributions. 100% of elective contributions up to 1% of compensation and 50% of elective contributions between 1% and 6% of compensation.
- Nonelective contributions. 3% of every eligible employee’s compensation, regardless of whether the employee participates in the plan.
The minimum rate of matching contributions for a QACA is less than that for other 401(k) plan safe harbors. Additionally, employer contributions under a QACA are not required to fully vest until the employee completes two years of service, which is slower than under other 401(k) safe harbors, which require immediate vesting.
Eligible Automatic Contribution Arrangements (“EACA”)
To further encourage the growth of automatic contribution arrangements, the Pension Protection Act of 2006 provided that for plan years beginning on or after January 1, 2008, automatic contribution arrangements may permit employees to elect a refund of their elective contributions within 90 days of the date on which they are enrolled. Withdrawals of elective contributions are normally not permitted except upon the occurrence of certain events, such as severance from employment, death or disability, the attainment of age 59½ or financial hardship. Further, an additional 10% tax ordinarily applies to early distributions from tax-qualified retirement plans that are not rolled over into another tax-qualified plan or individual retirement account. However, under an EACA, participants may elect to receive a distribution of default elective contributions, along with associated earnings (or losses) within 90 days of beginning participation without being subject to the early distribution tax.
- Applicable Plan. An EACA can be implemented in a 401(k) plan, a 403(b) plan, or a 457(b) plan. A 401(k) plan can implement an EACA regardless of whether it has implemented the QACA safe harbor.
- Uniform Default Contribution Rate. A uniform default contribution rate must apply for elective contributions. The permitted differences in contribution rates for a QACA (as discussed above) also apply to an EACA.
- Investment of Default Elective Contributions. The default elective contributions must be invested in accordance with the final regulations recently published by the Department of Labor regarding qualified default investment alternatives. This requirement will apply only if the applicable plan is otherwise subject to Title I of ERISA. Thus, governmental plans will not be subject to these investment requirements.
- No Bar to Future Participation. An employer cannot condition a 90-day withdrawal upon a participant’s election not to participate in the plan in the future. Amount of Withdrawal. The amount distributed for a 90-day withdrawal will be the actual amount of the default elective contributions, adjusted for any gains (or losses) and may be further reduced by an applicable fees so long as the fees are typically charged for other kinds of distributions. Any matching contributions made on the default elective contributions must be treated as forfeitures under the plan.
- Tax Treatment. The refunded default elective contributions will be includible in gross income in the year distributed, but will not be subject to additional early distribution taxes. If the refunded contributions include designated Roth contributions, the designated Roth contributions will not be included in the employee’s gross income, as they would have already been included in gross income.
- Distribution of Excess Contributions. The period in which excess contributions or excess aggregate contributions must be distributed to avoid the excise tax under section 4979(a) is extended to 6 months for a plan with an EACA, compared to 2 ½ months for plans without an EACA.
Notice Requirements for QACAs and EACAs.
Both QACAs and EACAs require an annual notice written in a manner calculated to be understood by the average employee.
- Timing. The notice must be provided a reasonable time before the beginning of each plan year. This requirement is deemed to be satisfied if the notice is provided 30 to 90 days before the beginning of the plan year. In the case of an employee who becomes eligible to participate in the plan after the 90th day before the first day of the plan year, this requirement is deemed to be satisfied if the notice is provided no later than the date on which the employee becomes eligible to participate in the plan.
- Content. The annual notice for a QACA must satisfy the notice content requirements that apply for other 401(k) plan safe harbors, including a description of the types of employer contributions and the conditions under which they are made, the amount and type of compensation that may be deferred and the procedures for making deferral elections, the vesting and withdrawal provisions under the plan, and how to obtain additional information about the plan. Notices for QACAs and EACAs must describe the following additional information that cannot be described by cross-reference to the summary plan description:
- The level of elective contributions that will be made if the employee does not make an affirmative election;
- The employee’s rights to opt out of default elective contributions or to contribute at a different rate;
- A description of how default elective contributions will be invested in the absence of any investment election by the employee; and
- The employee’s rights to make a 90-day withdrawal, if this right is available under the plan, and the procedures for making such withdrawals.
- Written Notice. The notice also must be in writing, although it may be provided electronically, if the regular requirements for providing notices electronically are satisfied.
- Model Notice. The Service has published a sample notice on its website. However, the Service has cautioned that the sample notice should only be used as a guide and customized to describe a plan’s features accurately. Coordinated Notices. The IRS and the Department of Labor coordinated the notice requirements for QACAs, EACAs, and qualified default investment alternatives. A plan can satisfy each of these notice requirements with a single notice.