Automatic Enrollment

Automatic enrollment is a feature of an employer retirement plan under which an eligible employee is treated as having elected to defer a set percentage of pay into the plan until they say otherwise. Formally it is an eligible automatic contribution arrangement, defined in Internal Revenue Code section 414(w)(3) as an arrangement under which the participant "is treated as having elected" to have contributions made at a uniform percentage of compensation "until the participant specifically elects not to have such contributions made." Since SECURE 2.0 added section 414A, titled "Requirements related to automatic enrollment," the design is a condition of qualification for most newly established 401(k) plans and 403(b) salary reduction agreements rather than a choice the sponsor makes.

The mandate has four moving parts and they are one requirement. Section 414A(b) says a plan meets the automatic enrollment requirements only if it is an eligible automatic contribution arrangement that also (1) allows permissible withdrawals, (2) sets an initial uniform deferral percentage "not less than 3 percent and not more than 10 percent," (3) increases that percentage "by 1 percentage point" effective the first day of each plan year following each completed year of participation, "to at least 10 percent, but not more than 15 percent," and (4) invests contributions for which the participant made no election in accordance with the Department of Labor's qualified default investment alternative regulation. Escalation is therefore not a bolt-on that a plan can decline; it sits in the same subsection as the enrollment itself. Every percentage in section 414A is a fixed statutory figure and none of them is adjusted for inflation.

Who is exempt. Four categories. Plans and 403(b) arrangements established before the statute's enactment date of December 29, 2022 are grandfathered, which is why many long-running 401(k) plans still have no automatic enrollment. Governmental plans and church plans are excluded. So is a plan while the employer and any predecessor "has been in existence for less than 3 years." And a small employer is exempt until one year after the close of the first taxable year in which it "normally employed more than 10 employees," so the obligation arrives with a year's notice rather than on the day of the eleventh hire. SIMPLE plans are outside the section altogether. The amendments apply to plan years beginning after December 31, 2024.

The 90-day undo is the least-known part and the most useful. Because the mandate requires an eligible automatic contribution arrangement, the plan must permit a permissible withdrawal under section 414(w). An employee who was enrolled without acting can elect, no later than 90 days after the first contribution, to take back everything contributed under the arrangement plus the earnings on it. The statute is precise about the treatment: the amount is includible in gross income for the year of the distribution, "no tax shall be imposed under section 72(t)," and employer matching contributions attributable to it are forfeited. The withdrawal is also disregarded for nondiscrimination testing and for the annual deferral limit, so it does not consume any of the employee's contribution room.

The notice is what makes the default fair, and it has to say where the money goes. Section 414(w)(4) requires the plan administrator to give each covered employee, within a reasonable period before each plan year, a notice accurate and comprehensive enough to explain their rights, written to be understood by the average employee, that explains the right to opt out or choose a different percentage, allows a reasonable period to act before the first contribution, and "explains how contributions made under the arrangement will be invested in the absence of any investment election." That last clause is the hinge between automatic enrollment and the plan's default investment.

Why this is lawful at all. Withholding money from wages without written authorization runs into state wage-payment law. The Department of Labor's regulation records the answer: ERISA section 514(e)(1) "supersedes any State law that would directly or indirectly prohibit or restrict the inclusion in any plan of an automatic contribution arrangement." Without that preemption the design would be unavailable in much of the country.

Two things automatic enrollment is not. It is not the qualified automatic contribution arrangement, or QACA, which is a safe harbor design with its own and different minimum schedule and its own vesting rules; that belongs with safe harbor 401(k) plans. And it is not the state-run automatic IRA programs that several states operate for workers whose employers offer no plan. Those are separate state regimes with their own default rates and enrollment mechanics, not section 414A.

A small side benefit. Being an eligible automatic contribution arrangement also extends the window for correcting a failed deferral or contribution percentage test without excise tax, from 2½ months after the plan year to 6 months.

A new employee becomes eligible, receives the required notice, and does nothing. The plan begins withholding the default percentage from pay. The money is invested in the plan's default investment because no election was made. On the first day of each subsequent plan year following a completed year of participation, the percentage rises by one point until it reaches the plan's ceiling. At any point the employee can change the percentage, stop contributing, or choose different investments, and within the first 90 days can undo the whole thing.

A hypothetical example. Jamal earns $50,000 and is automatically enrolled at 3%, so $1,500 goes into the plan in his first year of participation. Escalation adds a point a year, so assuming flat pay his fifth year runs at 7%, which is $3,500, and he reaches the 10% floor in his eighth year of participation. Had he instead decided in month two that he could not afford it, he could have elected a permissible withdrawal within 90 days of his first contribution and received back what had been deferred plus earnings, reporting it as income for that year with no 10% additional tax, and forfeiting any match attributable to it.

Pros

• Participation rates rise sharply, because the decision that determines whether someone saves is no longer a form they have to find.
• Escalation raises the rate over time without requiring a new decision each year, which is where most of the long-run benefit comes from.
• The 90-day permissible withdrawal gives a genuine exit, including the money back, for an employee who cannot afford it.
• Federal preemption of state wage-withholding law makes the design uniform across states.

Cons

• The default rate is not a recommendation. Starting at 3% is well below what most retirement projections assume, and anchoring on the default is a real cost.
• Employees who never engage may also never review the default investment, the beneficiary designation, or whether they are capturing the full match.
• An employee living close to the line can be enrolled without noticing and find take-home pay lower than expected, which is what the 90-day withdrawal exists to address.
• Grandfathering means two employees at similar companies can face completely different defaults for no reason other than when the plan was set up.