Automatic Enrollment and Increases for New 401(k) Plans and 403(b) Plans

The SECURE 2.0 Act requires that newly established 401(k) and private sector 403(b) plans must automatically enroll their eligible employees and provide for annual automatic deferral increases.

This new requirement applies to plans “established” on or after the enactment date—December 29, 2022. However, those plans don’t need to add the automatic enrollment and escalation provisions until their plan years beginning after December 31, 2024. The new requirement doesn’t apply to 401(k) and 403(b) plans established before the enactment date.

The initial deferral rate must be at least 3% of compensation, but not more than 10%. Each year thereafter, the deferral rate must be increased at least 1% per year—to at least 10%, but no more than 15%. As with any automatically enrolled plan, employees can opt out of deferring and/or change their deferral rates.

The accounts of defaulting participants must be invested in a qualified default investment alternative (QDIA).

In addition to plans established before December 29, 2022, other specified types of plans are excepted from these requirements:

• Government and church plans.
• New businesses: The requirement won’t apply until a new business has been in existence for more than three years.
• Small businesses: The requirement won’t apply until one year after the taxable year in which the employer had more than 10 employees.
• Multiple Employer Plans (MEPs) and Pooled Employer Plans (PEPs): The auto requirement doesn’t apply to a MEP or PEP as a whole; however, the requirement does apply to employers who adopt a MEP or PEP as if they were adopting a single employer plan on or after the enactment date. 

Comment: The difference between the effective date for plans that will be covered by this provision and the effective date for actually implementing the auto features is a trap for the unwary. Financial professionals should educate any employers who are considering adopting a 401(k) or 403(b) that, if they adopt a new plan, the plan will need to be automatically enrolled in 2025. Some of those employers may decide to start their plans as auto-compliant plans, rather than wait and make the change in 2025.

The SECURE 2.0 Act provides for extraordinary tax credits for both administrative and contribution costs of setting up a new plan.

Tax Credit for Small Plan Start Up Costs

Effective for tax years beginning after December 31, 2022, the SECURE 2.0 Act provides for extraordinary tax credits for both the administrative and contribution costs of setting up a new plan.

The current three-year start up credit is 50% of the administrative costs, up to $5,000.

That percent is increased to:

• 100% for employers with up to 50 employees, with a pro-ratable phase out for between 51 and 100 employees.

The Act adds a new credit for the costs of contributions made by employers (except for contributions to defined benefit plans). The credit is a percent of the contributions made by the employer for the participants up to $1,000 per participant:

• The credit is 100% for the first 2 years, 75% in the 3rd, 50% in the 4th, 25% in the 5th, and nothing after that.
• An employer gets 100% of the available credit if it has up to 50 employees and the credit phases out pro-ratably up to 100 employees.
• The credit doesn’t apply to contributions for employees who make over $100,000 in a year (adjusted for cost of living).

The start-up credits are available to employers who set up (i) qualified retirement plans, (ii) SIMPLE IRA arrangements and (iii) SEP IRA arrangements. The credits are also available for qualifying employers who set up single-employer arrangements or who join PEPs or MEPs.

Comment: These new tax credits are extraordinary because they can make a new plan virtually free for the first two years, and the costs are materially offset for the three years after that. Financial professionals who work in the start-up market should be educating small employers about these credits. For some employers, this may be a sufficient incentive to form a qualified plan rather than to be forced into complying with state-mandated IRA arrangements.

Multiple Employer 403(b) Plans

The SECURE 2.0 Act amends the Internal Revenue Code to create a new type of 403(b) plan that can be sponsored by multiple qualifying employers and includes MEPs and PEPs. 

The provision is effective for plan years beginning after December 31, 2022.

The 403(b) PEP provisions for non-governmental plans closely parallel the requirements for qualified plan PEPs; for example, the plan must have a pooled plan provider (PPP). 

While this change is effective now, it will likely take months before MEP and PEP providers are able to make plans available to qualifying employers.

Comment: Since the 403(b) PEPs are similar to qualified plan PEPs, financial professionals who have worked with the qualified plan PEPs (created by SECURE 1.0) will already be familiar with the basic structure and the considerations for these arrangements. Financial professionals who work with 403(b) plans should consider the new PEPs as an option for charities, private schools, and non-profits that would like to transfer as much of the fiduciary responsibility and administrative work as possible. The PPP will serve as the primary fiduciary for the plan and have ultimate administrative responsibility. Properly done, the 403(b) MEPs and PEPs should be able to provide investments at significantly lower costs, particularly for smaller employers.

Defined contribution plans can allow participants to elect to receive matching contributions on a Roth basis.

Changes to Expand Roth Availability

• Employer Contributions as Roth Contributions: Defined contribution plans can—but are not obligated to— allow participants to elect to receive matching contributions on a Roth basis.

Comment: This alternative is likely to be attractive to employers with college educated, younger employees. That would include almost all professional firms, such as law firms, engineers, high tech, and architecture firms. Financial professionals should consider educating their plan sponsors who fit that mold or who might otherwise be interested in giving this opportunity to their employees.

• SIMPLE and SEP Roth IRAs: SIMPLE and SEP IRAs can accept Roth contributions and allow employers to offer participants the ability to treat contributions as Roth.

Comment: Congress uses the availability of Roth treatment as “pay for’s” for other provisions that have a “tax cost” in the form of deductions. Roth treatment results in immediate taxation, but the distributions can be tax-free. Under Congressional budgeting practices, the window for the analysis is only 10 years. Since the first 10 years will primarily consist of after-tax Roth contributions, and most of the distributions will occur after the 10-year window closes, Roth is considered to be a net tax revenue source. From a longer-term perspective, if a taxpayer is in the same marginal tax rate when withdrawing as when contributing, Roth and pre-tax contributions should produce the same result. From a tax planning perspective, the key is to make Roth contributions in low-income tax years, and then withdraw the accounts in higher tax years.

Increase in Age for RMDs

Under current law, the law requires minimum distributions beginning at age 72. The Act further increases the ages.

• If a person attains age 72 after December 31, 2022*, the new RMD beginning age is 73.
• For a person who attains age 74 after December 31, 2032, the RMD beginning age will be 75.

*Note: The statute says the date for the increase to age 73 is tax years after 12-31-2032. However, that appears to be a drafting error and technical corrections are expected.

Additional Provisions in the Act

Those are the Act provisions that are already effective and will likely require the earliest attention by financial professionals and plan sponsors. However, there are a number of other provisions that are already effective and that warrant comment, as well as a few beyond the scope of this article.

• Small financial incentives for contributing to a plan: Under prior law, employers could not give financial incentives to employees to join and contribute to a plan—other than matching contributions. Now, however, employers can offer de minimis financial incentives, not paid for with plan assets (such as low-dollar gift cards), to boost participation in 401(k) and 403(b) plans. This will allow employers to use gamification to increase participation.
• Self-certification of hardship conditions: Fiduciaries can rely on participant self-certification that (i) a hardship distribution is on account of a qualifying need, (ii) the amount doesn’t exceed what’s needed, and (iii) a reasonably available alternative source of funds isn’t available. This change should ease the work for administering hardship withdrawal provisions.
• Reduction in RMD excise tax: The excise tax for failure to take an RMD is reduced from 50% to 25%. Further, if the RMD failure is corrected on a timely basis, the excise tax is reduced to 10%.
• RMD relief for partial annuitization: If a tax-preferred retirement account holds an annuity and other assets, prior law required that the RMD requirements be satisfied for each part separately. The Act changes the rule to allow distributions from both parts of the retirement account to be aggregated to satisfy the amount of the RMD.
• Expanding RMD flexibility for annuities: The change will allow the RMD rules to be satisfied where certain incidental benefits are included as a part of a life annuity, e.g., small annual guaranteed increases, return of premium death benefits, and participating annuities.
• Enhancement of 403(b) Plans: The Act amends Code §403(b)(7) to permit custodial accounts to participate in group trusts. Unfortunately, absent a securities law exemption, collective investment trusts (CITs) cannot be included in 403(b) plans. As a result, a technical correction will be required before CITs can be used by 403(b) plans.
  

The SECURE 2.0 Act has a wide array of provisions that will enhance retirement plans.

Concluding Thoughts

The SECURE 2.0 Act has a wide array of provisions that will enhance retirement plans and their flexibility. The effective dates start immediately and then extend out over several years. While this article discusses the provisions that are already effective, future articles will look at those that will become effective in the years ahead.

Several of the provisions discussed in this article could be “game changers.” That includes:

• The provision requiring automatic enrollment and increases beginning in 2025—but that will then apply to 401(k) or private sector 403(b) plans established on or after December 29, 2022. In 2025 and the years that follow, the norm will be “automatic plans.”
• The credit for administrative and contribution costs for newly established 401(k) plans. If employers are educated on the benefits of these extraordinary tax credits, it should lead to the formation of a substantial number of new plans.
• MEPs and PEPs for 403(b) plans. Small and mid-sized charities, private schools and tax-exempt entities could benefit from these pooled arrangements, with lower investment costs, a shifting of fiduciary responsibility, and a reduction in administrative work.

The SECURE 2.0 Act has laid the foundation to the expansion and improvement of retirement plans. And that creates an opportunity for financial professionals to do well while doing good, that is, to grow their client base while improving outcomes for plan sponsors and participants.