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.
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.
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.
The tax law includes two other important auto-enrollment rules:
- 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.
- 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% 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% 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.
An Example of the Rules in Action
Let’s say your company’s 401(k) plan installs an auto‑enrollment arrangement with escalating safe-harbor contribution percentages.
An employee named Ben doesn’t opt out of the program. Let’s assume:
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.
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