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Set your 401(k) on ‘autopilot’ to stockpile more for retirement

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in Small Business Tax

You can’t deny that a 401(k) plan is an excellent deal. You defer part of your salary to an account where it can grow tax-deferred. Usually, your company will match part or all of your deferral.

But, if you’re one of the company’s top wage earners, you must contend with annual limits on contribution amounts. Even worse, contributions for highly compensated employees (HCEs) may be reduced under strict nondiscrimination rules if enough lower-compensated employees don’t join in the plan.

Strategy: Turn your 401(k) into an auto-enrollment plan. Amend the existing plan document so that employees are enrolled automatically, unless they opt out. Otherwise, a “default contribution” is made on their behalf.

By adding this feature, it’s likely that a higher percentage of non-HCEs will participate in the plan. So you should be able to stockpile even more money for retirement.

Is it legal? Absolutely. In fact, the recently passed Pension Protection Act of 2006 (PPA) encourages auto-enrollment plans, effective for 2008.

Here’s the whole story: The dollar limit on deferrals to a 401(k) for 2007 is $15,500. Plus, you can defer an extra $5,000 if you’re age 50 or older. Icing on the cake: Within limits, the employer can provide matching contributions (e.g., 50 cents on the dollar) that also grow tax-deferred.

To qualify for those tax benefits, the plan must satisfy tough testing requirements to ensure that it doesn’t discriminate in favor of HCEs.

For starters, the plan must meet participation and vesting rules that apply to all tax-qualified plans. In addition, a 401(k) plan must pass both an actual deferral percentage (ADP) test for pre-tax contributions and an actual contribution percentage (ACP) test for matching contributions.

If the 401(k) plan fails on either count, the employer has to make corrective distributions to HCEs or kick in extra contributions for non- HCEs. Safe-harbor rule: The employer can satisfy the rules if it provides minimum contributions of at least 3% of compensation to the lower-paid group.

If some of your employees don’t participate in the plan, it could rain on your parade, one way or another.

The auto-enrollment feature generally eliminates the doubt. More employees are inclined to go along with the program if they must take action to decide against it. With the auto-enrollment feature, the plan should be able to easily pass both of the tough nondiscrimination tests.

Prior to the PPA, the IRS gave its blessing to auto-enrollment, provided that employees were properly notified and could revoke the automatic deferral at a later date. Proposed regulations issued in 2006 spell out the rules for establishing investment defaults.

Tip: An auto-enrollment plan can help lower-paid employees save for retirement when they otherwise would not have done so. So everyone benefits under this type of setup.

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