Final regulations were recently released regarding automatic contribution arrangements. The Pension Protection Act of 2006 (PPA) created the automatic contribution arrangements (both Qualified Automatic Contribution Arrangements (QACAs) and the Eligible Automatic Contribution Arrangement (EACAs)) effective for plan years beginning in 2008 or later. These plans should have been operating in good-faith compliance with the proposed regulations that were issued in November 2007.
An EACA is a feature in a 401(k) plan that provides for the automatic enrollment at a uniform default percentage for all covered employees who do not have an affirmative deferral election in effect. Subject to certain limitations, participants covered by an EACA can request a permissible withdrawal of the amounts automatically withheld during the first 90 days, and sponsors of EACAs generally have an extended deadline of six months following the end of the plan year (instead of the regular 2½ months) to distribute excess contributions to avoid imposition of the 10 percent penalty.
A QACA is a new type of safe-harbor 401(k) plan that combines the automatic enrollment feature of the EACA with the automatic escalation of the default percentage each year. In order to constitute a QACA, the employer must provide a matching contribution of 100 percent of the first 1 percent of contributions made by the employee and 50 percent of all further contributions up to a maximum of 6 percent of compensation. Therefore, the maximum match from the employer would be 4 percent. Unless the employee elects otherwise, the automatic contribution under QACA that will be made starts at 3 percent and escalates 1 percent each year until it reaches a maximum of 6 percent. An employee can, at any time, elect out of the arrangement or elect a different contribution percentage. The automatic contribution arrangement does not have to apply to any employee who already has an election in effect at the time the QACA was added to the 401(k) plan.
Also, if a QACA is used, then within a reasonable period before each plan year, each of the eligible employees must receive a notice of the fact that a QACA is in place and the rights and obligations concerning that arrangement.
If a plan adopts the QACA provisions, it will avoid having to do annual ADP testing to determine whether the deferral percentages of the plan satisfy the general requirements of the Code. Because the amount that highly compensated employees can defer under ADP testing is dependent on the amount that the other employees defer, ADP testing can depress the deferrals available to the more highly compensated employees. As a consequence, many plans prefer to use a safe-harbor approach such as QACA or the other safe harbors available to 401(k) plans, which requires that certain matching percentages or a 3 percent contribution be automatically made for the participants.
Under the proposed regulations, the notice requirements must have been provided at least 30 days, and no more than 90 days, before the beginning of each plan year. In the case of an employee who begins participation during the year, the proposed regulations required that the notice be provided no more than 90 days before the employee became eligible and no later than the date the employee becomes eligible. However, for newly enrolled employees, the proposed regulations also required that the employee have a reasonable period of time after receipt of the notice and before the first contribution is made under the default election to make an affirmative election to either not contribute or contribute a different amount.
A number of groups were concerned with this requirement because many plans that use this provision provide for immediate eligibility upon hire. Employers did not want to provide the newly hired employee with a first paycheck that did not include the 401(k) contribution followed by subsequent paychecks that were reduced to account for the default election. The concern was that this would motivate employees to elect out of the 401(k) plan.
The final regulations modified this notice requirement for newly enrolled participants by providing that if it is not practicable for the notice to be provided before the employee becomes eligible, it will still be considered timely if it is provided as soon as practicable after that date. As a result, the employer is required to provide the notice before the first pay date for such an employee.
In the final regulations, the IRS has continued to take the position that these safe-harbor plans cannot be adopted mid-year. This provision has caused controversy among some commentators. The IRS has taken the position that plans that are 401(k) safe-harbor plans must satisfy the safe harbor or otherwise fail to qualify as a 401(k) plan. They do not permit the safe-harbor plans to alternatively be tested under the ADP rules. In furtherance of this position, the IRS has required that a QACA safe-harbor plan must be adopted on a full plan year basis and cannot be added to a 401(k) plan mid-year. Thus, even though the regulations are technically effective in 2008, employers will not be able to adopt a new QACA arrangement until 2010, since that will be the next full calendar year in which the notice could be provided at least 30 days before the beginning of the plan year.
Treas. Reg. §§1.401(k)-2, 1.401(k)-3, 1.414(w)-1.
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