Why Your 401(k) Plan Should Feature Automatic Enrollment

by | Mar 18, 2022 | Uncategorized

Your company might offer a 401(k) retirement savings plan to employees. But do you have an automatic enrollment feature? It could boost participation and even provide some tax benefits. The Setting Every Community Up for Retirement Savings (SECURE) Act of 2019 — and proposed legislation, dubbed SECURE Act 2.0 — offers incentives for employers to use automatic enrollment.

The automatic enrollment feature might be available with other qualified retirement plans. However, for simplicity’s sake, this article will focus on 401(k) plans.

The Basics

When enrolled in a 401(k) plan, employees can elect to defer a specified part of their pretax earnings to an individual savings account. For 2022, the limit is $20,500, or $27,000 if they’re age 50 or older. Enrollees are offered a selection of investments, such as mutual funds, and their contributions can grow tax-free until they make withdrawals (usually, when they’re retired).

Many employers provide matching contributions, up to a stated percentage of workers’ salaries. A typical match is equal to 3% of an employee’s compensation. But your plan must comply with a strict set of nondiscrimination rules to preserve the tax benefits of matching contributions.

If your plan doesn’t have automatic enrollment, employees must proactively sign up and agree to defer part of their salaries. But if you have automatic enrollment, employees are included (generally from their start dates or another specified date), unless they explicitly opt out.

Everyone Participates

With automatic enrollment, your company determines a percentage of employees’ salaries that will automatically be deferred. You may also include a provision that provides for the deferral percentage to gradually increase over time.

For example, it may start at 3% of compensation and increase by one percentage point a year until the deferral tops out at 10%. However, employees can choose to stick with 3% or elect another percentage, so long as their contributions don’t exceed the annual limit.

The advantage of going this route is that you enroll employees who might not otherwise participate. For instance, employees in their 20s might not recognize the advantages of saving for retirement when it seems so far in the future. Other workers could feel they don’t have the extra income to defer or they may be intimidated by the prospect of choosing investments and managing their accounts.

Although non-enrolling individuals tend to be lower-wage workers, automatic enrollment can also help you prevent compliance problems associated with highly compensated employees (HCEs). Generally, a 401(k) plan must satisfy both an actual deferral percentage test for pretax contributions and an actual contribution percentage test for matching contributions. If a 401(k) plan fails either test, the employer is required to make corrective distributions to HCEs or provide extra contributions for non-HCEs. But you may be able to avoid this scenario by increasing overall participation in your company’s 401(k).

Note: Under a special safe-harbor rule, employers may provide minimum contributions of at least 3% of compensation to non-HCEs.  

Tax Incentives

The SECURE Act includes several provisions related to qualified plan and IRA participation. When it went into effect, the law closed a loophole for “stretch IRAs” that generally allowed nonspousal beneficiaries to extend required distributions over their lifetimes. It also boosted tax incentives for employers to establish retirement plans for employees and to use automatic enrollment.

Qualified small businesses (those with 100 or fewer employees) previously could claim a tax credit equal to 50% of costs for starting up a plan to a maximum of $500. Beginning in 2020, the credit limit increased to the greater of:

  1. $500, or
  2. The lesser of $5,000 or $250 multiplied by the number of non-HCEs eligible to participate in the plan.

The credit may be claimed for the first three plan years. The law also created a new tax credit of $500 a year for qualified small businesses that automatically enroll plan participants. This credit is available for the first three plan years as well. The credit can be claimed by employers that convert an existing plan to one that includes an automatic enrollment feature. You might even be eligible for both the start-up cost credit and the automatic enrollment credit.

Finally, the SECURE Act extends 401(k) eligibility to more part-time workers. Previously, employees had to work at least 1,000 hours per year before they could participate in an employer-sponsored retirement plan. Now, employees working at least 500 hours per year for three consecutive years can enroll, so long as they meet other plan requirements (for example, they’re at least 21 years old).

On the Way

More rules and incentives could be on the way. For example, the proposed SECURE Act 2.0 would generally mandate automatic enrollment for all new plans. In the meantime, consider the benefits of automatic enrollment if your company’s plan doesn’t currently include this feature.