The CPA Journal

IRS Releases Guidance on Default Elections

By Peter S. Altwardt, CPA, KPMG LLP

The IRS has issued new guidance to help employers increase employee participation rates in IRC section 403(b) plans and IRC section 457 plans by allowing default elections in such plans. IRS Revenue Rulings 2000-33 and 2000-35 follow Revenue Ruling 2000-8, which allows default elections for IRC section 401(k) plans.

The IRS is now supportive of default elections and has also issued an announcement encouraging prototype plan sponsors to add language permitting default elections. In a recent speech, Treasury Department Secretary Lawrence H. Summers highlighted default elections as an important way to encourage employee savings.

Background

More than eight years ago, an employer asked whether it could make employees’ 401(k) salary reduction election for them while telling them that they could elect out. The IRS unofficially agreed that this would be acceptable. In Revenue Ruling 98-30, the IRS laid out rules for making such default elections. Revenue Ruling 2000-8 updated and expanded on these rules to make it easier for 401(k) plan sponsors to use default elections (also called negative or automatic elections), including guidance in making default elections for current employees.

Congress and the IRS have also long been concerned about the disparity between elective contributions made by highly compensated and nonhighly compensated employees. The safe harbor provisions of the IRC and the Small Business Job Protection Act of 1996 (which became effective in 1999) were a congressional attempt to encourage employers to match nonhighly compensated employees’ contributions in return for an automatic waiver on the average deferral percentage (ADP) and average contribution percentage (ACP) discrimination tests. Unfortunately, safe harbor plans can require expensive contributions that some employers are not willing or able to make.

In a default election, the employer makes the elective contribution election for the employee, who then has the right to elect out of the contribution. In addition to being easier and less expensive to implement than a safe harbor plan, anecdotal evidence indicates that this approach works. Nonhighly compensated employees give many reasons for not making elective contributions, generally including not being able to afford a contribution; however, when small elective contributions are made for them, a large percentage of these employees fail to elect out.

In a 401(k) plan, the increased participation rate directly benefits highly compensated employees by making it easier for the plan to satisfy the ADP and ACP discrimination tests. The default election increases the average deferral percentage of the nonhighly compensated employees and therefore increases the amount that can remain in the plan for highly compensated employees. For example, if nonhighly compensated employees have deferred, on average, 3% of their compensation into the plan, highly compensated employees can, on average, keep deferrals of only 5% in the plan. If this can be raised to 4% using a default election, highly compensated employees could keep an average of 6% of deferred compensation in the plan.

In IRC section 403(b) and section 457 plans, the employer does not need to satisfy the ADP test [although a 403(b) plan must satisfy the ACP test with respect to matching contributions and after-tax employee contributions]. However, many employers are concerned that employees are not adequately saving for retirement or rely too heavily on the employer’s pension plan. Thus, even in IRC section 403(b) and section 457 plans, the employer may be interested in increasing plan participation.

New Revenue Rulings

Under these new revenue rulings, an employer can choose a stated rate of elective contributions for all employees, generally 2–4% (Revenue Ruling 2000-33 uses a 4% election as an example). Along with prior simplification of the rules for testing employee and employer contributions to retirement plans, the rulings may make compliance with the nondiscrimination rules easier than ever.

Interestingly, Revenue Ruling 2000-35 seems to suggest that the employer could boost the contribution percentage of employees already contributing to a higher target level. For example, if the employer has chosen a 3% default election, this can apparently be used to increase the election percentage of employees that have elected to contribute less than 3%.

Conditions. The following conditions must be met for an employer to use default elections:

The employee must have an “effective opportunity” to elect out and receive cash instead of the plan contribution.

A reasonable time before the choice is effective, the employee must receive notice explaining the automatic election and the procedure for electing out. An employee hired after the effective date must also be given notice of the automatic election and the procedure for electing out.

The election must apply to amounts not yet “currently available” (i.e., not yet earned). For IRC section 457 plans, which do not technically have a “currently available” concept, an agreement made before the beginning of a month with respect to the employee’s compensation for the month is acceptable.

Each employee must be notified annually of his or her deferral percentage and his or her right to change the percentage or elect out.

Until the participant directs otherwise, the deferrals will be invested in the plan’s balanced fund, including both diversified equity and fixed-income investments. The IRS points out that the Department of Labor believes that the fiduciary relief under ERISA IRC section 404(c) will not apply if the participant has not elected the investments.

From the examples in the rulings, the IRS seems to favor beginning these default elections at the beginning of the plan year, with adequate notice before that date.

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

Mitchell J. Smilowitz
GBS Retirement Services Inc.

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