The Pension Protection Act of 2006 (the “PPA”) added automatic contribution arrangements to the Internal Revenue Code (the “Code”) for use in Code section 401(k), 457(b) and 403(b) plans. On November 8, 2007, the Internal Revenue Service (“IRS”) issued proposed regulations relating to the automatic contribution arrangement provisions of the PPA (see our December 2007 issue for a discussion of the proposed regulations), which were effective January 1, 2008 and which could be relied on until the final regulations were issued. On February 24, 2009, the IRS published the longawaited final regulations relating to these arrangements. The final regulations adopt many of the provisions in the proposed regulations, with some modifications, and also include some new provisions. This article will describe the most significant changes made to automatic contribution arrangements (and the proposed regulations) by the final regulations.
Under an automatic contribution arrangement (“ACA”), an employee is automatically enrolled in a salary deferral plan (e.g., a 401(k), 403(b) or 457(b) plan) and treated as having made an election to have a specified percentage of compensation contributed to the plan, unless the employee affirmatively elects not to participate or to participate at a different level. The PPA created two new types of ACAs. The first is a new safe harbor design for automatic enrollment plans called a qualified automatic contribution arrangement (“QACA”). Plans that meet the QACA requirements in Code section 401(k)(13) will be deemed to satisfy the actual deferral percentage (“ADP”) and the actual contribution percentage (“ACP”) nondiscrimination tests that apply to salary deferrals and employer matching contributions, as well as the top-heavy rules. To qualify as a QACA, the arrangement must satisfy design-based safe harbor requirements such as qualified minimum contribution percentages, an initial and annual employee notice, and certain vesting rules for matching contributions. The second new type of ACA is an eligible automatic contribution arrangement (“EACA”). Plans that meet the EACA requirements in Code section 414(w) may allow employees to elect to withdraw automatic contributions within a 90-day period, without incurring the 10% early withdrawal penalty tax. The EACA requirements include uniform default deferral rates and initial and annual employee notices that are generally similar to those for a QACA, but do not include the minimum contribution or special vesting requirements.
One of the most significant changes in the final regulations is the modification of the application of automatic enrollment rules for EACAs to allow employers to adopt automatic enrollment only for employees who are specified under the plan as being covered by the EACA. For instance, this allows employers to adopt automatic enrollment only for employees who are hired or become eligible after a certain date. Thus, under the final regulations an employer can choose to cover only employees first hired after the effective date of the automatic enrollment arrangement. This is a change from the proposed regulations, which required all employees who did not have an affirmative election on file with the plan (including an election not to participate) to be automatically enrolled in order for the arrangement to be an EACA. However, note that plans that choose this new limited coverage option may not take advantage of the 6-month extended ADP and ACP testing period.
The final regulations also provide guidance for employers that may want to establish multiple EACAs in order to take advantage of the new relaxed rules governing automatic enrollment. The final regulations provide that groups that can be disaggregated under Code section 410(b) (e.g. collectively bargained employees, employees who have not worked 1000 hours, etc.) are tested separately in order to satisfy the uniformity requirement. For example, an employer could establish an EACA for collectively bargained employees with a 3% deferral rate and a separate EACA for non-collectively bargained employees with a 4% deferral rate. However, to satisfy the uniformity requirements an employer must aggregate all EACAs covering employees who cannot be disaggregated under Code section 410(b). For example, if an employer established an EACA for non-union hourly workers with a 3% deferral rate and a separate arrangement for salaried employees with a 4% deferral rate, the EACAs would not satisfy the uniformity requirement under the final regulations.
The final regulations also confirm that a QACA may permit mid-year escalation (e.g., from 3% to 4% deferral rate) as long as the application is uniform. This was not clear in the proposed regulations and was included in the final regulations in response to comments from employers who indicated a desire to time escalation with salary increases that may occur mid-year. The IRS has indicated that in order to comply with the uniformity requirement, the salary increases must occur at the same time for all covered employees, not at different times throughout the year.
Important guidance was provided in the final regulations on the impact of termination of employment and subsequent rehire on a participant’s default deferral rate under a QACA. The final regulations provide that the default deferral rate upon rehire is tied to the participant’s most recent default deferrals and, thus, upon rehire the participant stays on his or her original schedule. However, an employer may reset the initial period (e.g., the employee would go back to a 3% deferral rate upon rehire even if he or she was at the 5% deferral rate when he or she terminated employment) if there had been no default deferrals during the full plan year immediately preceding the participant’s rehire date. Please note that this is a permissive feature that must be set forth in the plan document.
It was unclear in the proposed regulations whether an employer could place an expiration date on existing affirmative elections. This is permitted under the final regulations. For example, an employer could provide in the plan document that:
- on December 31st of each year all existing affirmative elections expire, and all employees will be automatically enrolled, unless they affirmatively re-elect not to participate or to participate at a different level; or
- all affirmative elections expire at the end of the 6-month suspension period after a hardship distribution, and a participant will be automatically enrolled at the end of that period unless he or she makes an affirmative election otherwise.
Plans that satisfy all of the requirements to be an EACA may allow automatically-enrolled employees to opt out of the plan and request a distribution within the first 30 to 90 days following automatic enrollment. These so-called permissible withdrawals are:
- excluded from the annual nondiscrimination test;
- included in the individual’s taxable income in the year of distribution; and
- excluded from the early withdrawal penalty tax.
The final regulations clarify that the 90-day period begins on the date of the first withholding and not the date the salary deferral is allocated to the plan. Also clarified is the rule that a plan may specify a shorter timeframe for a participant to request an permissible withdrawal, such as 60 days (but no less than 30 days). The final regulations also address permissive withdrawals and rehired employees. The same “reset” rules discussed above apply and, thus, if no default deferrals were made during the full plan year immediately preceding rehire the employee can make permissive withdrawals, but only for amounts contributed after his or her rehire date.
A significant change also was made to the forfeiture of the related matching contributions that occurs if a participant elects to make a permissive withdrawal. The proposed regulations required an employer to forfeit the related matching contribution immediately. Thus, if the employer had not deposited the matching contribution at the time the permissive withdrawal is made, the employer was required to immediately deposit the matching contribution and then forfeit it from the participant’s account. The final regulations provide that an employer can wait until it otherwise would have made the related matching contribution before it deposits and forfeits the matching contribution.
Finally, the final regulations provide employers greater latitude with respect to the fees charged for the permissive withdrawal. The proposed regulations provided that the fees could not be different than ordinary distribution fees. Thus, the fee had to be identical. The final regulations provide that the fees related to the permissive withdrawal cannot be greater than the ordinary distribution fees, thereby permitting an employer to charge a lesser fee for permissive withdrawals if they so desire.
All automatic enrollment plans are required to provide a notice to participants within a reasonable period of time prior to start of each plan year. For newly-eligible employees, the notice must be provided within a reasonable period prior to their eligibility date. “Reasonable” is generally defined as 30 to 90 days. However, the final regulations provide that for immediate entry plans, the employer must allow sufficient time for the participant to act after receipt of the notice. Absent an affirmative election, the final regulations provide that in an immediateentry plan the default rate shall be applied no later than the earlier of:
- the pay date for the second pay period beginning after the notice is distributed; or
- the first pay date occurring at least 30 days after the notice is distributed.
The final regulations also provide that the notice for an EACA only has to be provided to each participant covered by the EACA and does not have to be provided to those who have opted out. Because this was unclear in the proposed regulations, some thought the annual notice had to be provided to all employees.
Timing and Implementation
An EACA or a QACA can only be added to an existing 401(k), 457(b) or 403(b) plan at the beginning of a plan year. To implement one of these arrangements for 2010, the participant notice must be distributed between October 1 and December 1 of 2009, and the plan must be formally amended by the last day of this year.
The provisions of the final regulations relating to QACAs apply retroactively to plan years beginning on or after January 1, 2008. The provisions of the final regulations relating to EACAs apply to plan years beginning on or after January 1, 2010; but good-faith compliance is required for plan years beginning in 2008 and 2009.
What Employers Should Do
The final regulations provide greater certainty for employers who sponsor a plan with a QACA or an EACA. For QACAs already in existence, employers will want to ensure that the features of their QACA are consistent with the final regulations as soon as possible, given the retroactive effective date. With the later effective date applicable to the final EACA rules — which are not effective until the 2010 plan year — employers have more time to confirm compliance with the final regulations. Nonetheless, employers should take steps now to examine their EACA arrangements to ensure compliance by the due date (and to satisfy the good faith compliance requirement applicable in 2008 and 2009).
Please give us a call if you have any questions regarding these rules.