The ERISA consultants at the Learning Center Resource Desk, which is available through Columbia Threadneedle Investments, regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with an advisor in Utah is representative of a common inquiry involving automatic escalation in a 401(k) plan. The advisor asked:
“Does the IRS have specific requirements that apply to an automatic escalation feature in a qualified automatic contribution arrangement (QACA) 401(k)?”
Highlights of Discussion
Yes, in addition to other requirements for a QACA, the auto-enrollment and escalation features in a QACA must satisfy a minimum and maximum amount related to the percentage of compensation (“default percentage”) that, in the absence of an affirmative election, is automatically deducted from employees’ wages and contributed to the plan as elective contributions [Internal Revenue Code Section 401(k)(13)(C)(iii)].
Under Treasury Regulation §1.401(k)-3(j)(2), in general, a default contribution percentage is a qualified percentage only if it is “uniform” for all eligible employees, does not exceed 10%, and satisfies certain minimum percentage requirements. The default percentage must be at least:
- 3% during the “initial period;”
- 4% during the first plan year following the initial period;
- 5% during the second plan year following the initial period; and
- 6% during the third and subsequent plan years following the initial period.
The initial period is the date an employee is first covered by the QACA through the end of the following plan year. For example, if an employee is eligible under the QACA on 02/01/17, the initial period may run through 12/31/18.
A uniform percentage, generally, means that the default percentage must be the same for every employee with the same number of years or portions of years since the beginning of the employee’s initial period. The percentage can vary to accommodate certain statutory restrictions, however. For example, the default election is not applied during the period an employee is not permitted to make elective contributions because of a six-month suspension following a hardship withdrawal under Treas. Reg. 1.401(k)-3(c)(6)(v)(B). (Please see Part 4 Examining Process Section 4.72.2.14.3 of the IRS’ Manual for further details and exceptions.)
A plan could avoid these automatic increases in the default percentage, often referred to as an “escalator,” by having just one default percentage of between 6 and 10% of compensation.
The IRS provides further clarification of QACAs in Revenue Ruling 2009-30.
Conclusion
Plan sponsors must be aware that the auto-enrollment and escalation features in a QACA must satisfy minimum and maximum contribution percentage requirements.
The Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC (RLC), a third-party industry consultant that is not affiliated with Columbia Threadneedle. Any information provided is for informational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Threadneedle does not provide tax or legal advice. Consumers consult with their tax advisor or attorney regarding their specific situation.
Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Columbia Threadneedle.
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