Some states have passed laws requiring employers, including many small businesses, to offer retirement plans to employees. Other states may follow in the coming years, with some form of a mandate. Often, these rules have an automatic enrollment feature.
Automatic enrollment plans may offer advantages to business owners, even if they’re not required. Federal law, in effect for the last decade, provides a roadmap to show you how to get those benefits and avoid problems.
In, unless they’re out
As the name implies, automatic enrollment plans put eligible workers into a company-sponsored retirement plan. These plans usually are 401(k)s, but they can be any type of plan that requires an employee contribution from earned income. Employers put a specified percentage of each covered worker’s earnings into the plan, although each employee can contribute more or less, if desired. Conversely, employees can opt out of the plan and, thus, avoid a reduction in current cash flow.
Among the acceptable arrangements, many companies choose a “qualified” automatic enrollment plan. These plans require at least a 3% employee contribution, gradually increasing each year, along with either:
- a matching contribution of 100% of an employee’s contribution up to 1% of compensation, and a 50% matching contribution for the employee’s contributions above 1% of compensation and up to 6% of compensation; or
- a nonelective contribution of 3% of compensation to all employees eligible to participate in the plan, including those who choose not to contribute any amount to the plan.
Commonly, employers choose to make the 3% nonelective contribution.
Example: XYZ Corp. enrolls employees Arlene Walker and Tim Miller in its 401(k) plan. Both have salaries of $40,000 a year. Arlene contributes 3% of her pay ($1,200), but Tim opts out and contributes nothing to the 401(k). Even so, XYZ contributes $1,200 to a 401(k) account for Tim as well as $1,200 to Arlene’s 401(k) account this year.
Thus, offering an automatic enrollment plan can be expensive, considering administration costs and employer contributions. Why should business owners consider them?
For one reason, offering a qualified automatic enrollment plan can meet safe harbor provisions that exempt the plan from annual nondiscrimination testing requirements. Without this safe harbor, low plan participation among middle- and lower-income workers might limit allowable tax-deferred contributions from key employees of the sponsoring company, including the business owner or owners.
Offering any retirement plan, moreover, can deliver intangible benefits. Having a plan may help a company hire and retain desirable workers. Employee morale and productivity might improve. Furthermore, many business owners will find satisfaction in providing their workers with increased retirement security.
Another safe harbor
With automatic enrollment arrangements, questions regarding investment selection may arise. Some employees may stay in the plan, yet not say how they want their money invested. If you put them into a bank account or money market fund, returns will be negligible; put them into stocks or bonds and any investment losses might trigger lawsuits from unhappy plan participants.
To address this concern, the federal government has designated certain investments as qualified default investment alternatives (QDIAs). If a retirement plan participant does not choose an investment, and the sponsor puts that employee’s money into a QDIA, the sponsor may be relieved of responsibility for poor investment results.
By far, the most popular QDIAs are life cycle funds, known as target date funds. (See the September 2016 CPA Client Bulletin for more on target date funds.) Balanced mutual funds (those holding equities and fixed-income securities) and professionally managed accounts also may be QDIAs. Stable value funds can be QDIAs, too, for certain short-time periods. All of these QDIAs may be used for any employer-sponsored retirement accounts when the participant does not select an investment, not just for automatic enrollment plans.
As might be expected, the rules on automatic enrollment plans can be complex. If you are interested in such a plan for your company, our office can help you comply with all the requirements.