IRS Proposes Regulations on Automatic Contribution Arrangements

The IRS has issued proposed regulations on automatic contribution arrangements under the Pension Protection Act of 2006 (PPA). The proposed regulations address the special 401(k) and 401(m) nondiscrimination test safe harbor for qualified automatic contribution arrangements (QACAs). The regulations also propose rules under which employees may disenroll from an eligible automatic contribution arrangement (EACA) and plans may return amounts requested by the employee within 90 days of the first default elective deferrals to the EACA, without the employee being subject to the 10 percent early withdrawal tax. In addition, sponsors of EACAs will have more time to distribute to participants 401(k) excess contributions and 401(m) excess aggregate contributions.

The regulations would take effect for plan years beginning on or after January 1, 2008, and sponsors may rely on the proposed regulations. If the final regulations are more restrictive than the proposed regulations, the more restrictive rules will not be made retroactive. Comments are due by February 6, 2008.

In other guidance relating to automatic contribution arrangements, the DOL recently released final regulations governing default investment alternatives in participant-directed individual account plans (see DOL Finalizes Qualified Default Investment Alternative Regulation).

Automatic Contribution Provisions – In General
In general, to qualify for the QACA nondiscrimination test safe harbor, a plan must meet several criteria:

• Uniformly defer a minimum and increasing percentage of compensation for eligible employees who fail to elect otherwise
• Allow participants to elect out of the plan or to choose a different deferral percentage
• Provide minimum employer matching or nonelective contributions on behalf of all eligible nonhighly compensated employees
• Meet vesting requirements for employer matching or nonelective contributions
• Comply with restrictions on distributions
• Provide a notice to participants

EACAs must, in general:

• Allow participants to elect to have the employer contribute elective deferrals to the plan on their behalf
• Make automatic contributions of default elective deferrals (calculated as a uniform percentage of compensation) to the plan on behalf of participants who do not make an election
• Satisfy ERISA’s requirements for default investments
• Provide a notice to participants

Qualified Automatic Contribution Arrangements
In a QACA, the plan provides a specified schedule of automatic deferral contributions (called qualified percentages) for each eligible employee. The starting percentage must be at least 3 percent of compensation. This minimum qualified percentage begins when the employee first participates in the automatic contribution arrangement and ends on the last day of the following plan year. So the initial period could be up to two full plan years. After this initial period, the employer must increase the percentage by at least 1 percentage point for each of the next three plan years. The employer may establish a higher percentage, but it may not exceed 10 percent of compensation.

The qualified percentage must be applied uniformly to all eligible employees. Under the proposed regulations, a plan would not fail this requirement merely because the percentage varied for the following reasons:

1. The percentage varies based on the number of years an eligible employee has participated in the automatic contribution arrangement intended to be a QACA.
2. Higher election percentages were already in effect on the effective date of the QACA.
3. The amount of elective deferral contributions is constrained by statutory limits on compensation, benefits or elective deferrals.

Further, under the proposed regulations, a cash or deferred arrangement will not fail to satisfy the uniformity requirement merely because an employee is not automatically enrolled during the six-month period after a hardship distribution.

There is an exception from the default elective contribution for current employees who were eligible to participate in the cash or deferred arrangement immediately before the QACA’s effective date and who already had an election in effect on the QACA’s effective date.

QACA Notices
Sponsors of a QACA generally must provide a safe harbor notice to all eligible employees at least 30 but no more than 90 days before each plan year. In addition to information required under the current-law safe harbor, the notice must explain:

• The employee’s right to elect not to have elective contributions made on his or her behalf or to elect a different deferral amount or percentage
• How contributions made under the automatic contribution arrangement will be invested if the employee does not choose the investment

If an employee becomes eligible after the 90th day before the beginning of the plan year, the plan sponsor generally must provide the notice no more than 90 days before the eligibility date and no later than the eligibility date. For plans with immediate eligibility, new employees generally must receive notice on their first day of employment.

These notice requirements cannot be satisfied by reference to the plan’s summary plan description. However, following coordination with the DOL, the IRS has posted a sample automatic enrollment notice on its Web site that satisfies requirements under ERISA and the tax code for a hypothetical QACA that permits EACA withdrawals and has certain other characteristics.

Permissible Withdrawals of Automatic Contributions
Plans with EACAs may optionally adopt a provision to return default elective deferrals (plus any associated earnings) requested by a participant within 90 days of the first elective deferrals to the arrangement.

Under the proposed regulations:

• Plan sponsors need not offer the permissible withdrawal feature to all employees eligible under the EACA, but they may not make employees’ right to receive a distribution conditional on whether or not they elect future elective deferrals.
• The 90-day window for the withdrawal election begins on the date the amounts would have been includible in the participant’s gross income had they not been contributed, and the effective date of the election must be on or before the last day of the payroll period beginning after the date of the election.
• The distribution generally is the employee’s account balance attributable to the default elective deferrals, adjusted for gains and losses, and any generally applicable fees (the plan may not charge a different fee for this distribution than it would for other distributions).
• Withdrawn amounts – except for designated Roth contributions – are includible in the employee’s gross income (and reported on Form 1099-R) in the year of distribution but are not subject to the 10 percent early withdrawal tax penalty.
• Any employer matching contributions with respect to the amounts withdrawn must be forfeited.

Corrective Distributions of Excess Contributions
The proposed regulations also reflect the PPA amendments permitting an EACA to distribute 401(k) excess contributions and 401(m) excess aggregate contributions to participants within six months (rather than 2½ months) after the close of the plan year in which the contributions were made. This provision, which will affect corrective distributions made in 2009, gives plans more time to make corrective distributions without triggering the 10 percent excise tax on the employer. These distributions are included in the employee’s gross income for the taxable year in which they are distributed. The distributions need not include income allocable to the period after the end of the plan year (i.e., the “gap period income”).