(Non)Testing Grounds
What exactly is a qualified automatic contribution arrangement?
Reported by Quana C Jew
So, what is required to play in this arena and is one design more advantageous than the other?
1. Employee Pre-Tax Deferrals. Eligible employees who have not elected to participate are automatically enrolled at a deferral rate of at least 3% of compensation. The minimum contribution of 3% increases by 1% each subsequent plan year, up to a cap of 6% per plan year. A plan may be designed to require an initially higher annual percentage than 3% and may escalate to 10%. (Of course, participants always have the right to opt out of the automatic contribution and/or the auto-escalation features.) Note that a 401(k) safe harbor plan does not require either automatic contribution or auto-escalation.
2. Employer Contributions. Similar to 401(k) safe harbor plans, QACAs are required to provide certain minimum employer contributions on behalf of all non-highly compensated employees. The requirement can be met either as a nonelective contribution equal to at least 3% of the eligible employee’s compensation or as a matching contribution equal to 100% of the employee’s pre-tax deferrals that do not exceed 1% of the employee’s compensation and at least 50% of the contributions exceeding 1% but not 6% of the employee’s compensation. The 401(k) safe harbor plan also requires certain employer contributions, a requirement that can be met as a nonelective contribution equal to at least 3% of the eligible employee’s compensation. Alternatively, this requirement could be met as a matching contribution. Unlike the QACA, the basic matching contribution is an amount equal to a 100% match on the first 3% of compensation deferred plus a 50% match on the next 2% of compensation deferred.
3. Vesting/Withdrawal. Under a QACA, the employer contribution must be fully vested after no more than two years of service, and the rules on the withdrawal of employer contributions are the same rules that apply to employee pre-tax deferrals. Employer contributions are not available as a source for hardship distributions. By contrast, the employer contributions under a 401(k) safe harbor plan must be 100% vested, regardless of service. Finally, withdrawal restrictions for both employer and employee pre-tax deferrals are the same as the QACA requirements.
4. Notice Requirements. QACAs, like 401(k) safe harbor plans, are subject to certain notice requirements. The notice must describe, among other things, the automatic pre-tax deferrals, the employer contributions and the conditions under which such contributions are made, the vesting and withdrawal restrictions, the employee’s right to opt out or to contribute at a different rate, and information on the default investment. The proposed regulations are not clear as to whether the notice must be provided to all employees, or only to those who have not made an affirmative election to participate. Final regulations, which are expected to be released later this year, are likely to address this issue. The QACA notice must be provided at least 30 days prior to the beginning of the plan year or, in the case of new participants, prior to the date the employee becomes eligible. The 401(k) safe harbor annual notice must be provided to all eligible employees and the content/timing of the notice is similar to the QACA rules.
In general, a plan must be amended to be a QACA or a 401(k) safe harbor plan prior to the beginning of the plan year and must retain such status for a least a 12-month plan year. If plans have completed their 2007 testing, now is the time to begin analyzing whether either of these designs could eliminate the testing entirely for a future plan year and, ultimately, the much dreaded cost of correction.
Quana C Jew is a partner at the law firm of Arent Fox, focusing on ERISA, employee benefits,and executive compensation. Quana has served as a guest lecturer in the employee benefits area for various law school, bar seminar, and employee benefits-related organizations. Most recently, Washingtonian magazine named Quana as one of Washington’s best tax lawyers.