Automatic enrollment rules for 401(k) plans: new law aims to increase employee participation.

Because many Americans are not saving for retirement properly, a primary objective of the recently enacted Pension Protection Act of 2006 was to encourage employee participation in defined contribution plans by facilitating automatic enrollment in IRC sections 401(k) and 403(b) plans. For plan years beginning after 2006, companies can automatically enroll employees in a plan, with a prescribed percentage of the employee's pay automatically withdrawn from each paycheck.

NONDISCRIMINATION 

To encourage the use of automatic enrollment, employers that set up such systems (and meet certain rules) do not have to meet nondiscrimination tests that normally apply to employee deferrals and employers' matching contributions. The automatic contribution (stated as a percentage of compensation) must fall within a specified range and be consistently applied to every eligible employee. The employer also must make either a matching or nonelective contribution for each employee not considered "highly compensated." Employer contributions, whether matching or nonelective, must be completely vested after the employee has completed two years of service.

STATE LAW

In the past, a significant barrier to automatic enrollment was that some states prohibited companies from taking automatic deductions from an employee's pay. The 2006 act provides that federal law supersedes any state law that would prohibit or restrict automatic contribution arrangements.

INVESTMENT OPTIONS/FIDUCIARY LIABILITY

Another employer concern has been the fiduciary responsibility and liability for investment of contributions made to a plan through automatic enrollment. A 401(k) plan administrator who chooses the investments for a participant under an automatic enrollment plan has potential liability as a fiduciary. In contrast, when a participant selects his or her own investments, the administrator is protected from any liability involving investment choices. After 2006, as long as the administrator follows regulations issued by the Department of Labor on default investments and meets certain notice requirements, the participant will be treated as having made his or her own investment choices.

Fund types. The default investment may be either a "life cycle" or "targeted retirement date" fund; it must use a mix of equity and fixed income investments based on the participant's age, target retirement date or life expectancy.

Notice. In addition to the rules dealing with investment options, the plan must meet certain other requirements to avoid fiduciary liability. Plan participants must

* Have had the opportunity to choose in vestments, whether or not they have done so.

* Have been given at least 30 days notice before the default investments are made and before the beginning of each plan year.

* Be provided with all investment materials (for example, prospectuses and proxy materials) received by the plan.

* Have the opportunity at least once each quarter to transfer out of the default investment into other investments without penalty.

The plan also must offer a broad range of investment alternatives.

For more information, see Tax Clinic, "Automatic Enrollment in Sec. 401(k) and 403(b) Plans," by G. Edgar Adkins Jr. and Jeff Martin, in the February 2007 issue of The Tax Adviser.

--Lesli S. Laffie, editor

The Tax Adviser