IRS Proposes Regulations On Negative-Option 401(k) Plans

(Published December 6, 2007)

Negative-option 401(k) plans automatically enroll employees and make deductions from their pay; employees must opt out to receive their full pay. The IRS gave them the thumbs up several years ago, and the Pension Protection Act of 2006 (PPA) created a new safe harbor from non-discrimination testing for negative-option plans that meet certain standards. The IRS has now proposed regulations addressing negative-option plans. The proposed regs dovetail with final regulations issued by the Department of Labor (DOL) covering qualified default investment alternatives (QDIAs, see last month's Benefits Alert). The regs are proposed to become effective for plan years beginning January 1, 2008, but you may rely on them until final regs are issued.

Qualified Automatic Contribution Arrangements  

There are two types of negative-option plans. The proposed regs call negative-option plans that seek the protection of the PPA's non-discrimination testing safe harbor qualified automatic contribution arrangements (QACAs). However, negative-option plans aren't obliged to become QACAs. For non-QACA negative-option plans, all of the usual rules regarding non-discrimination testing, etc., apply. Plans that want to become QACAs, and, therefore, dispense with onerous non-discrimination testing, must meet these standards.

Uniform deferrals. Under the regs, the pre-tax deferral percentage must generally be the same for all participants. The regs state that plans won't violate this provision if the deferral percentage varies based on the number of years an employee has participated in the QACA. For plans that are converting to a QACA, the regs note that plans won't run afoul of the uniform-deferral rule if the rate of pre-tax deferrals that's in effect on the date the QACA goes into effect isn't reduced.

The initial minimum pre-tax deferral is 3% of compensation through the end of the plan year following the year of initial participation. The initial period for a participant could, therefore, last as long as two full plan years. The deferral percentage increases by 1% for each of the next three plan years, ending at 6% of compensation. The regs clarify that the percentages are minimums and that a QACA can provide for higher percentages, up to 10%. Employees' deferrals must be invested in QDIAs until they exercise ownership of those assets.

All current limits that apply to 401(k) contributions (e.g., the maximum pre-tax contribution amount of $15,500) apply to QACAs.

Employer contributions. QACAs satisfy non-discrimination testing by making matching or non-elective contributions for all participants. A QACA generally satisfies the matching contribution requirement if it contributes 100% of employees' pre-tax deferrals, up to 1% of compensation plus 50% of pre-tax contributions between 1% and 6% of compensation. Employers can skip matching contributions and make flat, non-elective contributions of 3%.

Employee vesting. For QACAs, employees with at least two years of service must be 100% vested in employer matching or non-elective contributions. This is somewhat more advantageous to employers than current safe-harbor plans, which require immediate vesting.

Affirmative elections. Under the regs, employees who were eligible to participate in the
401(k) plan immediately before it becomes a QACA, and who have an election in effect on the QACA's effective date (even if that election is 0%), are considered to have made an affirmative election to participate (or not) and, therefore, aren't covered by these regs. Suggestion: A careful review of employees' election forms, and a reminder to employees to complete election forms before the plan converts to a QACA, can avoid the QACA/QDIA regimen altogether. In line with the DOL's regs, these regs clarify that default elections cease to apply once employees opt out and go for salary, or choose another percentage to be deducted from their pay.

Notices. QACAs must furnish notice to participants at least 30 days (and no more than 90 days) before the beginning of each plan year. The notice must explain the QACA and inform participants of the opportunity to elect out of the program, or to change their default percentages. Employees eligible to participate on their first day must be provided with notice on that day.

The IRS has issued a sample Automatic Enrollment and Default Investment Notice. This sample notice will also satisfy plan sponsors' responsibilities to provide notice under the QDIA final regs. The IRS notes that sponsors may need to tweak the model to fit the circumstances. Helpfully, the IRS has also supplied a brief description of the QACA to which its sample relates.

Click here to see the sample Notice. 

Permissible Withdrawals Of Automatic Contributions  

The regs clarify that provisions regarding the withdrawal of automatic contributions apply to all negative-option plans, not just QACAs. Employees have 90 days after the first default contributions to elect distributions. Distributions aren't subject to the 10% early withdrawal tax. Employees who receive distributions forfeit any employer contribution. Important: These provisions apply only to default contributions made after plan years beginning January 1, 2008. These provisions will test your communication skills in two crucial ways.

• Even though employees want their money back, the regs clarify that plans need not include a provision that allows default contributions to be returned to employees. Employees, therefore, can only stop future default deferrals.
  

• You may have to explain why the amount refunded is less than the amount contributed. The regs also clarify that distributions of default contributions include any earnings or losses. In addition, the regs allow distributions to be reduced by generally applicable fees (i.e., the plan can't charge a different fee for this distribution than it would for other distributions).

Click here to read the proposed regs. 

Related Topic(s): Benefits