Rev. Rul. 98-30 allows automatic employee participation elections in Sec. 401(k) plans.

The IRS has recently authorized employers to withhold Sec. 401(k) contributions from employee paychecks unless otherwise notified by the employee. This ruling may significantly improve test results by increasing participation by nonhighly compensated employees (NCEs) and allowing for greater contributions by highly compensated employees (HCEs). Rev. Rul. 98-30 permits an employer to automatically withhold fixed-percentage Sec. 401(k) contributions, even if the employee makes no affirmative election. Although some plans already subscribe to this method, the Service never formally approved it before now. This ruling provides not only potential planning opportunities, but also settles previously unanswered questions.

In Rev. Rul. 98-30, the IRS applied the regulatory requirements in Regs. Sec. 1.401(k)-1 for elective deferrals under qualified cash or deferred arrangements. The Service held that the regulations do not require an employee to receive an amount in cash when he fails to make an affirmative election to have an amount contributed to a plan. The definition of a cash or deferred election in Regs. Sec. 1.401(k)-1 (a)(3)(i) means that the employee can elect between the employer paying cash (or some other taxable benefit) to him or contributing to a plan on his behalf. The employee has an effective opportunity to elect to receive an amount in cash if he receives notice of the availability of the automatic compensation reduction election and has a reasonable period to make the election. The employee is also allowed to revoke the default election at any time.

The facts in Rev. Rul. 98-30 involved a Sec. 401(k) profit-sharing plan in which newly hired employees were immediately eligible to participate; however, matching contributions did not start until one year of service was completed. At the time of hire (or within a reasonable period before the first paycheck), the employees received a notice explaining the automatic election to make contributions as a percentage of compensation to the plan, as well as information about the procedures and timing for exercising an election. They were also notified of their right to have no compensation reduction contributions made to the plan or to adjust the amount of those contributions.

If an employee did not affirmatively elect to receive cash or to have a different percentage withheld, his compensation was automatically reduced by 3% and contributed to the plan. The employee did have until a reasonable period before the first paycheck to request a different amount (or no amount). The election was effective until superseded by a later election. Elections received after the reasonable date for filing became effective for payroll periods beginning in the month following the date the election was filed. In subsequent years, the employee was notified of his compensation reduction percentage and his right to change it.

Under the plan, employees could invest in a broad range of investment funds. However, if no investment election was made, the trustee invested in a fund that included both diversified equity and fixed income investments.

A planning opportunity provided by this ruling involves an employer's ability to raise its average contribution percentage, because it is likely that participation by NCEs will increase. This will maximize the permitted elective deferrals of rices.

Potential problems could result, however, if the employer designs a plan with a high fixed percentage compensation reduction amount, because the ruling approved only a 3% deferral. Further, the ruling did not define the reasonable period in which affirmative elections can be made. Finally, the ruling noted that, under the Employee Retirement Income Security Act of 1974 (ERISA), a fiduciary must ensure that the plan is administered prudently and solely in the interest of plan participants and beneficiaries. ERISA does not provide protection for a fiduciary's investment decisions made on the participant's behalf in the absence of instructions to the contrary. A question could also arise as to ERISA's ability to override potential state laws that prohibit the withholding of amounts from an employee's paycheck without express written consent.