AUTOMATIC ENROLLMENT OF ELIGIBLE EMPLOYEES IN 401(K) PLANS

By J. Michael Bermensolo, Esq., Geller & Wind, Ltd.

The IRS recently declared in Revenue Ruling 98-30 that contributions to a 401(k) plan are no less elective contributions merely because they are automatically made to the plan whenever the employee fails to affirmatively elect to receive the contributions in cash, provided the employee has an effective opportunity to do so.

An employer maintained a qualified profit-sharing plan with a 401(k) cash or deferred arrangement. Under the plan, any employee may elect to have the employer make a contribution to the plan on his or her behalf in lieu of receiving the amount as cash compensation.

A newly hired employee is immediately eligible to participate in the plan. If the employee fails to affirmatively elect between a cash payment and an employer contribution to the plan, her compensation is automatically reduced by three percent and this amount is contributed to the plan. An election to forgo compensation reduction contributions, or to contribute a different percentage of compensation, can be made at any time. The election is effective for the first and all subsequent pay periods, remaining in effect until superseded by a later election. However, to be effective, an election must be filed when the employee is hired or, if later, within a reasonable period before compensation for the first pay period is made available to the employee.

When an employee is hired, a notice explaining the automatic compensation reduction election and the right to either elect to relinquish compensation reduction contributions or to change the amount of those contributions is received. This notice also describes the procedure for exercising that right and the timing of any such election. The employee is subsequently notified each year of her compensation reduction percentage and right to change it.

Law

Treasury Regulations section 1.401(k)-1(a)(3)(i) defines a cash or deferred election as any election (or modification of an earlier election) by an employee to have the employer either provide cash (or other taxable benefit) to the employee or contribute an amount to a plan.

The definition of a cash or deferral election requires that an employee be able to elect between a cash payment and a contribution to a plan. According to the IRS, the employee is not required to receive an amount in cash whenever she does not make an affirmative election to have that amount contributed to the plan, provided the employee had an effective opportunity to elect to receive that amount in cash. An employee is considered to have such an opportunity if notified of the election's availability and given a reasonable period to make the election before the cash is made available.

Ruling

Under the facts presented in Revenue Ruling 98-30, the employer's compensation reduction contributions to the plan (including those made if the employee has not filed an election) are amounts contributed pursuant to a procedure that provides notice explaining the employee's rights to have no compensation reduction contribution. After receiving the notice, the employee has a reasonable period before the cash is made available in which to elect to receive the same amount of cash in lieu of an employer contribution to the plan. An eligible employee therefore has an effective opportunity to elect to receive cash or to defer payments through
the plan.

The compensation reduction contributions under the plan in Revenue Ruling 98-30 are therefore made pursuant to a cash or deferred election, and satisfy the Regulations section 1.401(k)-1(a)(3)(i) requirement that the amount that each eligible employee may defer as an elective contribution be available to the employee in cash.

Thus, the IRS ruled that, where an employee has an effective opportunity to elect either cash or an employer contribution of a like amount to a 401(k) plan, the contributions will not lose their character as elective contributions under Regulations section 1.401(k)-1(g)(3) merely because they are made under an arrangement providing that a fixed percentage of the employee's pay will be contributed to the plan whenever an employee fails to affirmatively elect to receive cash.

The ruling allows employers to increase actual contribution percentages by including employees who would, by failing to make an election, otherwise limit the ability of highly compensated individuals to contribute. Prior IRS approval of negative elections was infrequent and occurred only in private letter rulings for specified employers that requested such a ruling. Notwithstanding the foregoing, an employer must consider the effect of an automatic enrollment program on the morale of its lowest-paid employees, who may not understand the procedures involved in reversing negative elections. *

AUTOMATIC ENROLLMENT IN 401(K) PLANS APPROVED BY IRS: ANOTHER PERSPECTIVE

By Peter Alwardt, CPA, KPMG Peat Marwick, LLP

Human inertia can be a blessing or curse in many areas of life, but especially in saving for retirement. Employers sponsoring contributory retirement plans are all too familiar with the employee who always intends to enroll for the plan, but somehow never quite gets around to actually submitting the authorization for contributions. In recent years, some 401(k) plan sponsors have reversed retirement savings inertia simply by informing new employees that the employee's earnings will be reduced and contributed to the 401(k) plan after a stated period unless the employee notifies the employer not to make the reduction and subsequent contribution.

Employers and plan sponsors found this an effective way to get--and keep--new hires in the plan. However, some employers were concerned such approaches might violate IRS rules. Recently, the IRS gave this "negative election" approach official approval in Revenue Ruling 98-30, which is applicable to all parties that meet the facts of the ruling. The IRS confirmed that, when an employee has an effective opportunity to elect to receive cash or have that amount contributed by the employer to a profit-sharing plan containing a 401(k) deferral provision, contributions made on the employee's behalf may be considered elective contributions within the meaning of Regulations section 1.401(k)-1(g)(3) even though the employee does not take some affirmative action to begin the deferral.

Requirements for Valid Negative Election

Under the facts of Revenue Ruling 98-30, newly hired employees are immediately eligible to participate in Plan A, which is a profit-sharing plan with both a 401(k) feature and an employer matching contribution provision. At the time of hire, the employee receives a notice explaining that Plan A has an automatic three percent compensation-reduction election. The notice informs the employee that he or she has the right to elect to have no such compensation-reduction contributions made to Plan A and the right to choose an amount other than the automatic three percent. The notice also includes procedures for making the election and explains when it takes effect. The employee is not notified annually of his or her compensation reduction percentage nor of the right to change the percentage or make no deferral at all.

IRS Reasoning

In arriving at its conclusion, the IRS reasoned that the definition of a cash or deferred election in Regulations section 1.401(k)-1(a)(3)(i) plans requires that the employee have an election between receiving cash (or some other taxable benefit) or having a contribution made to a trust on the employee's behalf. However, the regulation does not require that the employee receive an amount in cash even though the employee does not make an affirmative election to have that amount contributed to the trust.

Handling Investment Elections and After Tax Contributions

The IRS also discussed the issue of investment elections under these no-action enrollments. Obviously, an employee who fails to act on deciding whether to contribute to a plan will also be likely not to decide on how to invest these contributions. Under the facts outlined by the IRS, if a participant in Plan A has made a no-investment election, Plan A invests the amounts in a balanced fund that includes both diversified equity and fixed income investments. In its ruling, the IRS found this an acceptable method of acting for the participant.

But the IRS did include a warning in their ruling that the Department of Labor will not consider the participant or beneficiary to have exercised the type of control over investment choices that is necessary to justify relaxing fiduciary responsibilities in the ERISA section 404(c) regulations. In this case, the fact that the participant or beneficiary is merely told of the investments that will, in the absence of instructions to the contrary, be made on his or her behalf cannot be considered control by the participant.

Of course, an employee enrolled under a plan in a negative election retains the ability to gain control of investment decisions at the same time and to the same degree as any other participant in the plan. If at any time, a participant wanted to change the investment for the account, he or she could do so. Presumably, once a participant began managing his or her account's investments, if the plan otherwise met the requirements of ERISA section 404(c) regulations, the participant's actions would also be covered by those regulations. Consequently, a plan sponsor would have some fiduciary protection against the participant's actions.

Plan A, as discussed in the IRS ruling, did not permit after tax contributions. However, the IRS noted that if Plan A were to permit after tax employee contributions, then amounts contributed to the plan would have to be designated or treated at the time of the contribution as pretax compensation-reduction contributions or after tax contributions. Presumably, the plan sponsor could simply state the tax treatment of the contributions in the notice given to employees. Furthermore, given that the automatic amounts are likely to be in the modest range of one to five percent, and given the $160,000 limit on compensation that applies to tax-qualified retirement plans, no automatic election amount would likely exceed the pretax deferral limit of $10,000. Hence, there would be little reason to treat the automatic contributions as anything other than pretax deferrals.

Effect on Plans

Being able to use default enrollments should offer an easy way to increase plan enrollment and increase average deferral percentages, especially among nonhighly compensated employees. This may potentially benefit highly compensated employees if the increased deferral rate for the nonhighly compensated employees allows the highly compensated employees to increase their salary deferrals to the plan. *

Editors:
Sheldon M. Geller, Esq.
Geller & Wind, Ltd.