Publications

December 1998

Automatic Enrollment of Eligible Employees in 401(k) Plans

By J. Michael Bermensolo, Esq., Geller Group Ltd.

The IRS recently declared in Revenue Ruling 98-30 that contributions to a 401(k) plan are no less elective contributions merely because they are automatically made to the plan whenever the employee fails to affirmatively elect to receive the contributions in cash, provided the employee has an effective opportunity to do so.

An employer maintained a qualified profit-sharing plan with a 401(k) cash or deferred arrangement. Under the plan, any employee may elect to have the employer make a contribution to the plan on his or her behalf in lieu of receiving the amount as cash compensation.

A newly hired employee is immediately eligible to participate in the plan. If the employee fails to affirmatively elect between a cash payment and an employer contribution to the plan, her compensation is automatically reduced by three percent and this amount is contributed to the plan. An election to forgo compensation reduction contributions, or to contribute a different percentage of compensation, can be made at any time. The election is effective for the first and all subsequent pay periods, remaining in effect until superseded by a later election. However, to be effective, an election must be filed when the employee is hired or, if later, within a reasonable period before compensation for the first pay period is made available to the employee.

When an employee is hired, a notice explaining the automatic compensation reduction election and the right to either elect to relinquish compensation reduction contributions or to change the amount of those contributions is received. This notice also describes the procedure for exercising that right and the timing of any such election. The employee is subsequently notified each year of her compensation reduction percentage and right to change it.

Law

Treasury Regulations section 1.401(k)-1(a)(3)(i) defines a cash or deferred election as any election (or modification of an earlier election) by an employee to have the employer either provide cash (or other taxable benefit) to the employee or contribute an amount to a plan.

The definition of a cash or deferral election requires that an employee be able to elect between a cash payment and a contribution to a plan. According to the IRS, the employee is not required to receive an amount in cash whenever she does not make an affirmative election to have that amount contributed to the plan, provided the employee had an effective opportunity to elect to receive that amount in cash. An employee is considered to have such an opportunity if notified of the election's availability and given a reasonable period to make the election before the cash is made available.

Ruling

Under the facts presented in Revenue Ruling 98-30, the employer's compensation reduction contributions to the plan (including those made if the employee has not filed an election) are amounts contributed pursuant to a procedure that provides notice explaining the employee's rights to have no compensation reduction contribution. After receiving the notice, the employee has a reasonable period before the cash is made available in which to elect to receive the same amount of cash in lieu of an employer contribution to the plan. An eligible employee therefore has an effective opportunity to elect to receive cash or to defer payments through the plan.

The compensation reduction contributions under the plan in Revenue Ruling 98-30 are therefore made pursuant to a cash or deferred election, and satisfy the Regulations section 1.401(k)-1(a)(3)(i) requirement that the amount that each eligible employee may defer as an elective contribution be available to the employee in cash.

Thus, the IRS ruled that, where an employee has an effective opportunity to elect either cash or an employer contribution of a like amount to a 401(k) plan, the contributions will not lose their character as elective contributions under Regulations section 1.401(k)-1(g)(3) merely because they are made under an arrangement providing that a fixed percentage of the employee's pay will be contributed to the plan whenever an employee fails to affirmatively elect to receive cash.

The ruling allows employers to increase actual contribution percentages by including employees who would, by filling to make an election, otherwise limit the ability of highly compensated individuals to contribute. Prior IRS approval of negative elections was infrequent and occurred only in private letter rulings for specified employers that requested such a ruling. Notwithstanding the foregoing, an employer must consider the effect of an automatic enrollment program on the morale of its lowest-paid employees, who may not understand the procedures involved in reversing negative elections.