Beefing Up Your 401(k) Account - Automatically
By Marc J. Lane
401(k) plans are more popular than ever. They allow eligible employees to avoid current income tax on payroll-deducted savings, this year up to $10,500. The earnings on those savings also escape income tax until they are distributed. Particularly in a very competitive, full-employment environment, 401(k)s help employers recruit and retain good employees.
But many employees, especially those who are relatively low-paid, decide against 401(k) participation because they need every dollar they earn to met their living expenses. And, ironically, their opting out can hurt highly compensated employees, including the owners of businesses.
Two tricky tax tests - the "actual deferral percentage" test and the "actual contribution percentage" test - limit the right of high-paid employees to fund their 401(k)s. In the worst of cases, highly compensated employees are shut out of the benefit entirely. Yet, several planning strategies can prevent this result and benefit both the company and its employees.
One such strategy is "automatic enrollment" and it works this way: the 401(k) plan is written to "assume" that all employees want to participate until they declare otherwise. The level of participation that's usually set is 2 or 3% - high enough to help build retirement savings in a meaningful way, especially if the employer matches employee contributions, but small enough not to hurt most employees.
Experience indicates that automatic enrollment results in just about everybody staying with the plan and benefitting from it. It may also have the effect of allowing all high-paid employees to participate at or near the max.
As good as the automatic enrollment sounds, it raises some questions worth exploring with legal counsel. These include:
First, are the advantages of full enrollment likely to outweigh the additional cost to the employer, particularly if it matches employee contributions? Will the plan need to be amended? Should a waiting period be imposed? If not, employees' paychecks will never need to reflect a reduction in take-home pay. How should the employer invest the employee's plan contributions? The employer may be liable for imprudent investment decisions and might decide to invest "default savings" only in Treasuries or a money market, or it may allocate them among all the fund alternatives the plan offers. Either way, it's a good idea to encourage plan participants to make their own investment decisions, and profit from them, as soon as possible.
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