Guest Article

(From the November 12, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Proposes Guidance on More PPA Provisions Relating to Automatic Enrollment

Coming on the heels of the Department of Labor's final qualified default investment alternative (QDIA) regulations, the IRS on November 7, 2007 issued proposed guidance on other key Pension Protection Act (PPA) provisions designed to encourage 401(k), 403(b), and governmental 457 plan sponsors to adopt automatic enrollment arrangements. 72 FR 63144 (November 8, 2007). The following is a high-level summary of the IRS's proposed regulations; a more in-depth analysis will be published in a future edition of Washington Bulletin.

Background

The PPA made a series of amendments to ERISA and the Internal Revenue Code (IRC) to facilitate and encourage the use of automatic enrollment arrangements by 401(k), 403(b), and 457 governmental plans. (For convenience this article will focus only on 401(k) plans, although many of the rules are applicable to 403(b) and 457 plans as well.) These include:

The Department of Labor issued final regulations on the fiduciary safe harbor in late October. 72 FR 60452 (October 24, 2007). In addition to providing guidance on so-called "qualified default investment alternatives" (QDIAs), those final regulations also address the amendment to ERISA's preemption provision to specifically preempt any state laws -- including wage garnishment laws -- that would prevent a plan from implementing an "automatic contribution arrangement."

The IRS's proposed regulations build on the DOL's final rules with guidance on the PPA's automatic enrollment provisions under its jurisdiction: the ADP/ACP safe harbor and the permissive withdrawal rules.

ADP/ACP Safe Harbor

The PPA amended IRC § 401(k) and (m) to create a design-based ADP/ACP safe harbor for 401(k) plans with automatic enrollment features that meet certain requirements relating to (1) automatic deferrals, (2) employer contributions, and (3) notices to employees. Plans with these QACAs will be treated as satisfying the ADP and ACP nondiscrimination tests.

To satisfy the automatic deferral requirement, a plan must set its default deferral percentage for automatic enrollees at no less than three percent during the initial period, which begins when the employee first participates in the QACA and ends on the last day of the following plan year. Thus, the initial period could last as many as two full plan years. After the initial period, the minimum default deferral percentage increases by one percentage point for each of the next three plan years. So the minimum default deferral percentage must be at least four percent in the first plan year after the initial period, at least five percent in the second plan year after the initial period, and at least six percent in the third plan year after the initial period and thereafter. A plan can always establish higher default deferral percentages, but never more than ten percent.

The employer contribution requirement can be satisfied in either of two ways. One way is for the employer to make a three percent nonelective contribution on behalf of each nonhighly compensated employee who is eligible to participate in the automatic enrollment feature. The other way is for the employer to make matching contributions to eligible nonhighly compensated employees on a dollar-for-dollar basis up to one percent of compensation, and then on a 50 cent per dollar basis up to six percent of compensation. Also, the matching contribution rate for highly compensated employees cannot exceed the rate for nonhighly compensated employees. If the plan makes matching contributions to satisfy the employer contribution requirement it will need to meet additional standards to be deemed to pass the ACP test. Specifically --

Whether the employer chooses the nonelective or matching contribution options to satisfy the contribution requirement, the employer's contributions must become 100 percent vested after no more than two years of service. Also, these employer contributions will be subject to the same withdrawal restrictions that apply to employee elective deferrals.

Finally, in order to satisfy the notice requirement, employers must give each employee eligible to participate in the automatic enrollment feature a notice that explains --

After receiving the notice employees must have a "reasonable period of time" before the first elective deferral contribution to make an affirmative election with respect to contributions and investments. The proposed regulations would specify the notice timing requirement is deemed satisfied if the notice is given to each eligible employee at least 30 -- but no more than 90 -- days before the beginning of each plan year. For employees who become eligible after the 90th day before the start of a plan year, the proposed regulations would provide the timing requirement is deemed satisfied if the notice is provided on or before the date the employee becomes eligible -- but no more than 90 days before the employee becomes eligible.

The IRS is planning to post a sample QACA notice to its Web site.

Permissive Withdrawals

One concern some plan sponsors had with automatic enrollment was that automatic enrollees would opt out after a short period of time, leaving the plan with many small accounts to administer. As a result, the PPA created a special rule permitting plans to distribute "erroneous automatic contributions" within 90 days of an automatic enrollee's first elective contribution. See IRC § 414(w). These corrective distributions are treated as compensation, rather than as plan distributions. As a result, otherwise applicable withdrawal restrictions and the 10 percent penalty tax on early withdrawals do not apply. Also, these "erroneous automatic contributions" do not count for nondiscrimination testing purposes.

Only "Eligible Automatic Contribution Arrangements" (EACAs) may offer the permissive withdrawal option. An EACA, as defined by IRC § 414(w)(4) is an arrangement --

The proposed regulations would reaffirm that plans may offer the permissive withdrawal option, but are not required to do so. Also, the proposed regulations would provide that plans offering the permissive withdrawal option would not have to make it available to all employees eligible under the EACA. So it would be permissible for a plan to make the withdrawal option available only to employees who did not make any elective contributions before the EACA is effective, for example. However, 401(k) and 403(b) plans may not condition permissive withdrawals on electing not to make future elective contributions because that would violate the IRC § 401(k)(4)(A) contingent benefit rule or the IRC § 403(b)(12)(A)(ii) universal availability requirement.

The uniformity requirement for EACAs is like the uniformity requirement for QACAs. As a result, the proposed regulations would allow the same differences in contribution rates for EACAs as are permitted for QACAs. The notice requirement for EACAs also is similar to the notice requirement for QACAs. Thus, the proposed regulations would apply the same deemed timing rules to the EACA notice as it applies to the QACA notice.

As noted, permissive withdrawals are included in the participant's gross income in the year of distribution. (However, permissive withdrawals of designated Roth contributions are not included in gross income because the contributions were made on an after-tax basis.) These permissive withdrawals are not subject to the IRC § 72(t) 10 percent penalty, and are not eligible for rollover. The proposed regulations would require employers to report distributions pursuant to permissive withdrawals on Form 1099-R.

Any matching contribution an employer makes with respect to amounts distributed pursuant to a permissive withdrawal must be forfeited and treated as any other forfeiture under the plan's terms. These amounts may not be returned to the employer or distributed to the employee.

Coordinated Notices

The notice requirements for QACAs, EACAs, and the DOL's QDIA rules are similar in terms of content and timing. According to the preamble to the proposed regulations, the IRS and DOL anticipate all three notice requirements can be satisfied with a single document.

Effective Date

The QACA and EACA rules are effective for plan years beginning on or after January 1, 2008. Likewise, the IRS's regulations are proposed to be effective for plan years beginning on or after January 1, 2008. Until the IRS issues final regulations, plans may rely on the proposed regulations. That is a good thing for plan sponsors who want to implement QACAs and EACAs in 2008.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.