Automatic Enrollment – Is It Right for Your Small Business 401(k) Plan?

Gym memberships are profitable because people who long ago stopped going to the gym either forget about the reoccurring charge to their credit card or procrastinate on taking the steps to end it. This same human behavior is why a 401(k) plan’s automatic enrollment works. An employer deducts a certain portion of an employee’s pay and contributes it to the 401(k) plan unless the employee takes steps to prevent the deduction from occurring. Employees either don’t read the notice informing them of the upcoming deduction or fail to act before the deadline. Further, employees procrastinate in stopping the deduction after it begins. Contrary to gym memberships in which the gym owner reaps the reward, the benefactor of automatic enrollment is the employee whose forgetfulness or procrastination results in retirement savings. 

Automatic enrollment can be a useful mechanism in getting more employees to save for retirement through the 401(k) plan. There are different automatic enrollment options available to your business and these options each have unique features. We discuss the options and features below to assist you in deciding which one may be best for your business or whether the benefit of automatic enrollment exceeds the potential cost and complexity. 

Automatic Enrollment Options

The use of automatic enrollment goes back to at least the 90s and became more prevalent with a law change in the mid-2000s. Automatic enrollment can be added to a new or existing 401(k) plan. There are three general options for automatic enrollment with increased benefits and requirements:  

1. 1. automatic contribution arrangement (ACA) 

   2. eligible automatic contribution arrangement (EACA) 

   3. qualified automatic contribution arrangement (QACA) 

Congress recently passed SECURE 2.0 which makes automatic enrollment mandatory for most 401(k) plans starting in 2025. The mandated automatic enrollment (MACA) is required for: 

• • 401(k) plans established after December 29, 2022. 
  • Businesses in existence for at least three years. 
  • Businesses having more than 10 employees. 

We detail how MACAs should compare to the others below. However, there are still unresolved questions, and further guidance is needed from the IRS for MACAs. 

Does My Business Need Automatic Enrollment?

Before diving into the available options and how they compare to each other, you should first ask whether your 401(k) plan even needs automatic enrollment. The advantage of using automatic enrollment is usually to help employees accumulate retirement savings or improve annual testing results. As such, automatic enrollment may be unnecessary if your employees are actively participating in the plan or if you have a safe harbor 401(k) plan. 

To determine if automatic enrollment is right for your business, you’ll want to understand the different characteristics. Each automatic enrollment option has both common and unique features which should be compared to determine which one may be a good fit or if automatic enrollment is worth the trouble at all. 

Comparing Automatic Enrollment Options 

Each automatic enrollment option has features, such as default deferral rates, escalators, covered employees, notices, and distributions, which may be similar or different depending on the option. Below is a summary of these features to help you assess each automatic enrollment option.

Default Deferral Rate 

A “default deferral rate” determines the amount to be deducted from an employee’s pay and contributed to the 401(k) plan. An “escalator” is an increase in the default deferral rate over time.

A common default deferral rate is 3% of compensation. Depending upon the option selected, an employer may have the flexibility to choose a lower or higher rate than 3%. There is evidence that choosing a higher default deferral rate will not significantly decrease an employee’s participation in the plan. 

The uniform percentage of compensation requirement will be satisfied by most typical escalator structures. For example, a default deferral rate beginning at 3% of compensation and increasing 1% on each anniversary date of the employee’s date of hire up to a maximum of 10% of compensation. However, some escalator structures are not compliant. For example, setting a 3% default deferral rate for hourly employees and a 5% rate for salary employees or varying the escalator based on the amount of a pay raise. 

The default deferral amount must be invested in the available 401(k) plan options. If an employee has not selected a particular investment option(s), the employer must make the choice for the employee. Although not required by the current automatic enrollment options, many employers use a Qualified Default Investment Alternative (QDIA) fund as it provides fiduciary protection. However, the MACA option requires the use of a QDIA. 

Covered Employees 

Depending upon the automatic enrollment option, the employer may have the discretion to determine who will be affected by automatic enrollment. 

Plans adding automatic enrollment must generally implement it at the beginning of the plan year. However, an ACA, EACA and presumably a MACA can start in the middle of the plan year as long as the covered employees are only new hires. 

For an EACA or presumably a MACA, applying automatic enrollment to both new hires and existing employees provides the benefit of having 6 months (instead of the usual 2 ½ months) to complete certain annual testing. 

A QACA must cover any employee who has not made an affirmative election. For example, there are 23 employees currently eligible for the 401(k), but only 6 have made affirmative elections to contribute to the plan. The other 17 employees never filled out or submitted the salary deferral election form. To satisfy QACA requirements, all 17 employees would have to receive the QACA notice. If any of the 17 employees did not make a timely affirmative election, those employees would have the default deferral amount deducted from subsequent paychecks and contributed to the plan. 

Participant Notices

All automatic enrollment options require notices to be sent to the employees. The notices should contain the following: 

• • State the default deferral rate. 
  • Explain the employee’s right to elect not to have the default deferral rate apply or to have a lower deferral rate and how to make the election. 
  • Describe how the default deferral amount will be invested if no election is made by the employee. 
  • Inform the employee of his or her right to receive a distribution of the default deferral amount (if allowed) and how to elect the distribution. 

The notice must be provided within a reasonable time of the automatic enrollment applying to the employee and before each plan year. Reasonable generally means within 30-90 days of the first default deferral amount or the beginning of the plan year. For employers who apply automatic enrollment to new hires with no eligibility requirements, reasonable means before the first pay date in which the default deferral rate applies. This time allows an employee to understand the potential impact and how to make the affirmative election if desired before the default deferral rate kicks in.

Distribution of Default Deferrals

Although the ACA option allows the most flexibility, it does have a major downside: the inability to distribute default deferral amounts.  

To illustrate, an ACA is set up and covered employees timely receive the notice. An employee ignores the notice and subsequently has $96.15 deducted from his paycheck which is contributed to the 401(k) plan. This employee sees the deduction and is upset because he needs all available funds to make ends meet. He finds his notice and follows the steps to make the affirmative election to stop any further default deferrals. He also asks for the $96.15 to be returned to him as he didn’t realize the ACA’s impact. 

Unfortunately, you are unable to distribute that small account balance because it is like any other salary deferral. Distributions of salary deferrals are generally permitted upon termination of employment, age 59 ½ or death. You now have an upset employee who can’t get an immediate distribution and will continue to receive statements showing that small balance. Further, your 401(k) plan must now administer that small amount for potentially years which may add to plan fees and operational burden. 

This distribution nightmare can be resolved in an EACA, QACA, or MACA. These options allow an employer to distribute any default deferral amounts if the employee makes the request no more than 90 days from the initial default deferral.  

What Option is “Best” for You?

Before going into the “best” evaluation, you should first ask whether your 401(k) plan even needs automatic enrollment. Does your business need to use jedi mind tricks similar to gym memberships for employees to save for retirement? Or would engaging with employees to make affirmative elections be better than the additional administrative tasks along with the potential for costly mistakes? 

Determining whether to use automatic enrollment may be irrelevant with the MACA requirement in 2025. However, you can still avoid some administrative tasks and avoid costly mistakes with one action: ensure every employee makes an affirmative election. If you are engaging with employees to help them understand the benefits of contributing and providing reminders on making an affirmative election, most of the requirements above (except the notice) are irrelevant. 

Getting back to the “best” evaluation, an EACA is the most popular automatic enrollment option. The EACA has the added benefit over an ACA of being able to distribute default deferrals if timely requested. Although the QACA has the added benefit of automatically passing certain annual tests, its administrative complexity regarding prescribed default rates and escalators as well as determining covered employees may result in costly mistakes. 

Conclusion

Gym memberships work for a reason. Automatic enrollment is widely regarded as a powerful tool for spurring retirement savings. So much so that the federal government mandates it for most 401(k) plans starting in 2025. If you want to help employees help themselves or improve annual testing results, automatic enrollment may be a good fit for your 401(k) plan.  

To sweeten the deal, the federal government offers a $500 tax credit for the first three years that automatic enrollment, including MACA, is effective. If anyone needs me, I’ll be at the gym.