Automatic enrollment 401(k) plans can increase plan participation among rank-and-file employees and make it more likely the plan will pass the nondiscrimination test ordinarily required under a traditional 401(k) plan. Some automatic enrollment 401(k) plans are exempt from testing. This feature is for employers who want a high level of participation and also have highly compensated employees whose contributions would otherwise be limited under a traditional 401(k) plan.
Employees are automatically enrolled in the plan and contributions are deducted from their paychecks, unless they opt out of contributing after receiving notice from the plan.
There are default employee contribution rates. Additionally, for certain default investment options provided under the plan, there is relief from liability for the investment results.
If a 401(k) plan has an automatic enrollment feature, the employer automatically reduces an employee’s pay by a fixed percentage and contributes that amount to the 401(k) plan on their behalf unless the employee affirmatively chooses not to have their pay reduced or chooses to have it reduced by a different percentage. Automatic contributions are
considered elective deferrals.
Under an eligible automatic contribution arrangement (EACA), an employee is treated as having elected to make elective deferral contributions in an amount equal to a uniform percentage of compensation. The automatic election remains in effect until the employee elects otherwise. There is no required deferral percentage.
A qualified automatic contribution arrangement (QACA) is a safe harbor plan and contains an automatic enrollment feature and mandatory employer contributions are required. A plan that includes a QACA is not subject to the ADP test or the top-heavy requirements.
Under a QACA, each employee eligible to participate in the plan is treated as having elected to make elective deferral contributions equal to a certain default percentage of compensation. To avoid elective deferrals, an employee must make an affirmative election specifying a deferral percentage, including zero. The default deferral percentage must meet the following requirements [§401(k)(13)(C)(iii)]:
It must be applied uniformly.
It must not exceed 10%.
It must be at least 3% in the first plan year it applies to an employee and through the end of the first year.
It must increase to at least 4% in the second plan year.
It must increase to at least 5% in the third plan year.
It must increase to at least 6% in subsequent plan years.
Under the terms of the QACA, an employer must make either matching or nonelective contributions.
Matching contributions. An employer must make matching contributions on behalf of each NHCE in the following amounts:
An amount equal to 100% of elective deferrals, up to 1% of compensation.
An amount equal to 50% of elective deferrals, from 1% up to 6% of compensation.
Nonelective contributions. An employer must make nonelective contributions on behalf of every NHCE eligible to participate in the plan in an amount equal to at least 3% of their compensation. Contributions must be made regardless of whether the employee elected to participate.
Employer
For 2015, a 401(k) plan’s annual contributions and other additions, excluding earnings, to the account of a participant cannot exceed the lesser of:
100% of the participant’s compensation.
$53,000 ($52,000 for 2014).
An employer can make deductible contributions into the employee’s accounts. The employer deduction is limited by §404 and is reduced for other annual contributions that are made each year for plan participants.
An employer’s contribution must be made by the due date of the federal tax return,
including extensions, for that year. Generally contributions are applied to the year in which they are made unless all of the following requirements are met.
Contributions are made by the due date of the tax return for the previous year, including extensions.
The plan was established by the end of the previous year.
The plan treats contributions as though it had received them on the last day of the previous year.
The employer does either of the following:
Specifies in writing to the plan administrator or trustee that contributions apply to a previous year.
Deducts the contributions on the tax return for the previous year.
A 401(k) plan has deduction limitations for employer contributions. The deduction for contributions to a defined contribution plan cannot be more than 25% of compensation paid or accrued during the year to eligible employees participating in the plan. A self-employed taxpayer must reduce the limit in figuring the deduction for contributions made in their own account, similar to the reduction used for SEP IRAs.
The following rules apply when calculating the deduction limit.
Elective deferrals are not subject to the limit.
Compensation includes elective deferrals.
The maximum compensation that can be taken into account for each employee in 2015 is $265,000 ($260,000 for 2014).
Net earnings from self-employment for 401(k) contributions is figured in the same way as that for SEPs. Reduce Schedule C income by the deduction for ½ of self-employment tax and the contribution for the self-employed individual. Likewise, taxpayers can use the Deduction Worksheet for Self-Employed from Pub. 560 to determine the maximum deduction.
Example Madison, age 43, is self-employed and has established a 401(k) plan for her business. Madison’s plan provides for an employer contribution of 5% of compensation for all eligible employees. During 2015, Madison paid a total of
$265,000 of compensation to eligible employees and contributed $13,250 ($265,000 x 5%) to the employees’ retirement accounts. For 2015, Madison’s net earnings from self-employment are $42,000 (which includes the reduction for the employer-equivalent portion of the self-employment tax deduction).
Madison elected to defer $18,000 into the plan.
Madison’s deduction for 401(k) contributions made on her own behalf is as follows.
Employer contribution ($42,000 x 5%) $2,100
Elective deferral 18,000
Total deduction $20,100
Madison’s contributions on behalf of her employees is deductible on Schedule C, Line 19. Madison’s deductible 401(k) contributions for herself are not
reported on Schedule C. Instead, the deduction is reported on Form 1040, U.S.
Individual Income Tax Return, Line 28.
NOTE: Sole proprietors can reduce income tax, but not self-employment tax for his or her own contributions. Contributions on behalf of other employees reduce both.
If an employer has more than one plan, the contributions into the 401(k) plan can be limited by contributions to another retirement plan. The annual additions to a participant’s account are limited to the lesser of $53,000 for 2015 or 100% of the participant’s
compensation. In determining this limit, an employer must add all contributions made to all defined contribution plans maintained by the employer. A SEP is considered a defined contribution plan for this limit.
Example Jackson, a 46-year-old employee, has compensation of $310,000 and 401(k) contributions of $18,000 for 2015. Jackson’s taxable income is $292,500. His employer makes a contribution of $15,000 to the plan on Jackson’s behalf.
His employer’s deduction limit determined under §404 is $66,250 ($265,000 x 25%). Since the employer’s contribution on Jackson’s behalf is less than
$66,250, the employer can deduct the full contribution.