On November 8, 2007, the Internal Revenue Service (the “IRS”) issued proposed regulations implementing the new rules that facilitate the adoption of automatic contribution arrangements under 401(k), 403(b) and 457 plans (the “Proposed Regulations”). Specifically, the Pension Protection Act of 2006 (the “PPA”) provided that plans adopting automatic contribution arrangements that meet Internal Revenue Code (the “Code”) requirements will be deemed to have satisfied the Code’s non-discrimination testing requirements. The Proposed Regulations, which are effective for plan years beginning on or after January 1, 2008 and may be relied on pending the issuance of final regulations, provide further guidance on such arrangements.

Overview of PPA’s Automatic Contribution Arrangements

Under the PPA, a qualified automatic contribution arrangement (a “QACA”) is a safe harbor arrangement under which an employee becomes automatically enrolled in the employer’s plan unless the employee affirmatively elects not to participate. If a plan’s automatic contribution arrangement is “qualified,” i.e. the arrangement meets the criteria set forth under the PPA, the plan will automatically satisfy the actual deferral percentage and actual contribution percentage tests, as well as the Code’s top-heavy provisions.

QACAs must meet the following specified criteria to be eligible for this safe harbor: (i) the plan must provide for a minimum 3 percent deferral election that escalates in 1 percent minimum increments until it reaches 6 percent; (ii) employees must be notified of the QACA annually and be given the option to elect out; and (iii) the plan must make either a specified matching or non-elective contribution subject to certain vesting and withdrawal restrictions. While a QACA is permitted to establish a deferral election percentage higher than the minimums set forth above, at no time may the deferral election percentage exceed 10 percent of compensation.

In addition, the PPA permits employees to give automatically enrolled employees the ability to withdraw elective deferrals contributed through an eligible automatic contribution arrangement (an “EACA”) without being subject to early distribution penalties. EACAs must meet requirements similar to those applicable to a QACA, except that contributions lacking investment directions under an EACA must be invested in a qualified default investment alternative (a “QDIA”) described in section 404(c)(5) of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). For more information on QDIAs, please see our earlier e-Flash, DOL Releases Final Default Investment Regulation. The Proposed Regulations clarify, however, that this requirement only applies if the plan is otherwise subject to Title I of ERISA (in other words, government plans need not invest automatic contributions in a QDIA in order to have an EACA).

The Proposed Regulations

The Proposed Regulations provide employers with guidance on the mechanics of QACAs and EACAs. The key areas addressed by the Proposed Regulations are:

  • Notice. The PPA requires that each eligible employee enrolled in a QACA receive a safe harbor notice within a reasonable period before each year. The Proposed Regulations reiterate the timing and content requirements set forth in the PPA but add some additional clarifications. In particular, the Proposed Regulations interpret the timing requirements applicable to the notice, noting that the timing requirement is satisfied if at least 30 days (and no more than 90 days) before the beginning of each plan year the notice is provided. With respect to new employees who would not receive the notice in this time period, the Proposed Regulations indicates that the timing requirement would be satisfied if the notice is provided not more than 90 days before the employee becomes eligible. In the case of a plan with immediate eligibility, the deemed timing rule is satisfied if the employee is provided the notice on the first day of employment. Additionally, the Preamble to the Proposed Regulations clarifies that the QACA notice requirements cannot be satisfied by reference to the plan’s summary plan description (perhaps due to the timing requirements).

Plans that offer EACAs and QDIAs under ERISA must provide notice to employees with respect to each of these arrangements. The notice requirements applicable to EACAs and QDIAs are substantially similar to the requirements that apply to the QACA notice. The Preamble notes that the IRS, in coordination with the Department of Labor, anticipates that a single document can satisfy all of these notice requirements, so long as it has all of the requisite information for plan participants and satisfies the timing requirements for each of those notices.

  •  Uniformity. QACAs must apply a specified schedule of automatic contributions (qualified percentages) for each eligible employee and apply such percentage uniformly. The Proposed Regulations provide that a QACA does not fail the uniformity requirement merely because, among other reasons, (i) the percentage varies based on the number of years an employee has been a participant; (ii) the participant’s elective deferrals are limited in order not to exceed Code limits (e.g., 402(g) limits); or (iii) a participant is not permitted to be automatically enrolled during the 6 month period following a hardship distribution. The plan must provide, however, that elective deferrals will automatically resume after the end of the suspension period.
  • Affirmative Elections. The PPA provides that a default election under a QACA must cease to apply if an employee makes an affirmative election not to have such contributions made or to make elective contributions at a specified level. The Proposed Regulations clarify the requirements applicable to an “affirmative election,” noting that generally this would require an employee to have completed an election form and chosen an amount or percentage (including zero) of his or her compensation to be deferred. In other words, employees who fail to make any deferral election cannot be treated as having affirmatively elected a contribution of “zero.”
  • Matching or Nonelective Contributions. QACAs must provide for a specified level of matching or nonelective contributions, subject to certain vesting and distribution requirements. While the QACA permits a 2-year vesting schedule for both matching and nonelective safe harbor contributions, as opposed to the immediate vesting schedule imposed under the ACP safe harbor in Code section 401(k)(12), the Proposed Regulations apply the same distribution restrictions to QACA matching and nonelective contributions that would apply to the safe harbor contributions under section 401(k)(12). 
  • EACAs. The PPA also provides that employers may, but are not required to, offer an EACA, an arrangement in which an employee can be permitted to elect to receive a distribution equal to the amount of default elective deferrals (and earnings) made with respect to the first payroll period to which the EACA applies and any succeeding payroll periods beginning before the effective date of the election. The Proposed Regulations make clear that an employer who does offer this option is not required to make it available to all employees. For instance, an employer may want to make the withdrawal election available only to employees who did not make any elective deferrals to the plan before the EACA became effective. The Proposed Regulations also indicate that a withdrawal election under an EACA can only apply to elective deferrals made on or after January 1, 2008. Finally, the Proposed Regulations clarify the application of the 90-day window period available for withdrawals under an EACA, noting that the 90-day period begins on the date that compensation that is subject to the automatic election would be included in gross income. The Proposed Regulations also specify how matching contributions associated with withdrawn elective deferrals must be treated by requiring that the match not be returned to the participant or to the employer but instead remain in the plan’s forfeiture account.
  • Tax Consequence of Withdrawals Under an EACA. The amount withdrawn under an EACA is includible in gross income in the year in which it is withdrawn (except in the case of designated Roth contributions). However, such amounts are not subject to the additional 10 percent income tax penalty normally applicable to early distributions. Amounts withdrawn under an EACA are not eligible for rollover.
  • Corrective Distributions. The Proposed Regulations also reflect the PPA’s amendments, which permit an EACA to distribute excess contributions and excess aggregate contributions applicable to the EACA within six months, rather the previous 2 1/2 months, after the end of the plan year. Distributions of excess contributions and excess aggregate contributions (whether or not under an EACA) need not include gap period income. These changes are applicable to corrective distributions made in 2009. If you would like more information about QACAs, EACAs or QDIAs, please contact your Reed Smith attorney or one of the individuals listed below.