401(k) Automatic Enrollment: Definition And How It Works

In 2022 the government passed the Securing a Strong Retirement Act. This act is also known as SECURE Act 2.0 because it builds upon the Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed in December 2019.

Most employers offer retirement plans where enrollment is voluntary. These retirement plans are often considered a value add by the employer but employees may opt out of participating due to lack of education or financial hardship.

What Is Auto Enrollment?

In auto-enrollment plans, employees are automatically enrolled to contribute a certain portion of their salary each paycheck into a retirement savings plan. Participation in the plan requires no action on the employee’s part, but the employee can elect not to participate.

Part of the SECURE Act 2.0 is a provision that requires that employers creating new retirement savings plans, such as 401k plans, automatically enroll newly-hired workers once they meet eligibility requirements and at a pretax contribution rate of 3% of the employee’s salary. Additionally, the employee’s contribution would increase annually by 1% up to a minimum of 10%, but not greater than 15%.

Note: Under the SECURE Act 2.0, employees would be contributing between 10% and 15% of their annual salary toward retirement.

The new auto-enroll provisions apply only to 401k and 403b plans that have been created after the SECURE Act 2.0 plan’s enactment date, and do not apply to currently existing plans. Also, businesses having 10 or fewer employees, new businesses open for less than three years, and church and governmental plans are exempt from the auto-enrollment requirement.

How Does Auto Enrollment Work?

Automatic enrollment requires an employer to automatically deduct elective deferrals from an employee’s salary unless the employee decides not to contribute or decides to contribute a different amount. Plans that allow elective salary deferrals, such as 401k or SIMPLE IRA plans, can have automatic enrollment.

Employers most frequently set up a retirement plan with the help of a financial advisor, third-party administrator, and record keeper. The advisor will work with the record-keeping company and the third-party administrator (TPA) to:

Step 1: Create a Written Plan Document

Financial institutions typically have templates available and the plan can be a:

• Basic Automatic Enrollment Plan: also known as an Automatic Contribution Arrangement, or ACA, employees are automatically enrolled in the plan unless they elect otherwise, the plan document specifies the percentage of wages that will be automatically deducted, and employees can elect not to contribute or to contribute a different percentage of pay.
• Eligible Automatic Contribution Arrangement (EACA): uniformly applies the plan’s default deferral percentage to all employees after giving them the required notice, it may allow employees to withdraw automatic contributions, including earnings, within 90 days of the date of the first automatic contribution.
• Qualified Automatic Contribution Arrangement (QACA): a type of automatic enrollment 401k plan that undergoes required annual testing and meets certain requirements including a fixed schedule of automatic employee contributions, employer contributions, a special vesting schedule, and specific notice requirements.

Step 2: Create a Trust

This assures that the plan’s assets are used solely to benefit the participants and their beneficiaries, and the trust must have at least one trustee who handles contributions, investments, and distributions. If the trust is set up through insurance contracts, the contracts don’t need to be held in trust.

Step 3: Develop a Record-Keeping System

That tracks and attributes contributions, earnings and losses, plan investments, expenses, and benefit distributions. The record-keeping system will also record participants’ investment decisions and it will assist with the preparation of the retirement savings plan’s annual report that must be filed with the federal government.

Step 4: Distribute Plan Information

Employees must receive an initial notice prior to automatic enrollment in a plan and they must receive a similar notice each year. Also, a summary plan description that informs participants and beneficiaries about the plan and how it operates must be provided to all participants.

401k Automatic Enrollment Rules

The only employees that may be excluded from automatic enrollment in a 401k plan are those that:

• Are younger than age 21
• Have completed less than one year of service
• Are covered by a collective bargaining agreement
• Are certain nonresident aliens

Benefits to Employers of 401k Auto-Enrollment

Adding an automatic enrollment feature to their 401k plan:

• Helps employers attract and retain qualified employees
• Provides tax advantages, including the deduction of employer contributions and deferred taxation on employee contributions and earnings until distribution
• Makes it more likely that a plan will pass the Internal Revenue Code’s nondiscrimination testing
• Limits an employers’ potential fiduciary liability for losses to employees’ accounts due to the employer’s default investment option by including other default investments such as lifecycle funds, balanced funds, and managed accounts

SECURE Act & Auto-Enrollment in 2022

Should the SECURE Act 2.0 be passed by the Senate and become law, it would put pressure on existing retirement savings plans that don’t include automatic enrollment and automatic escalation. In an October 2021 research paper, Vanguard Investments raised the issue of automatic enrollment causing employers’ finances to become strained due to larger employer matching costs from increased retirement savings plan participation. However, Vanguard concluded that automatic enrollment typically added more lower-paid employees to plans resulting in a smaller employer cost increase.

According to a poll conducted by the Principal Financial Group in 2021 of more than 2,000 workers and retirees who had participated in an automatic enrollment plan, 84% said that they had been nudged toward saving for their retirement earlier than if participation in their plans had been voluntary.

Opting Out of Auto Enrolled 401k

Employees who opt out of participating in their employer’s automatic enrollment 401k plan can open one of several types of self-directed Individual Retirement Account. IRAs can be opened through banks, online brokers, or investment companies, and the types of IRAs include Traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.

Money held in IRAs usually can’t be withdrawn before age 59.5 without incurring tax penalties, and there are annual contribution limitations.

Bottom Line

While automatic enrollment plans significantly increase the number of people saving for their retirement and boost retirement savings accounts, they also eliminate some of employees’ agency over how they manage their money. This agency is further diminished with automatic enrollment combined with automatic escalation options. However, in the long haul, automatic enrollment is believed by many to be a step in the right direction of helping American citizens save for retirement.