Are you putting money into a 401(k) without even knowing it? Automatic enrollment plans allow an employer to take a portion of your paycheck and put it into a 401(k) on your behalf.
These plans gained popularity after the passage of the Pension Protection Act of 2006, which made it easier for employers to sign up workers. Employees don’t even have to take any steps to establish an account.
“There are a lot of people who are nervous about making a 401(k) enrollment decision. If you ask them to enroll, they may never get around to doing so because they don’t feel educated enough about their options,” says Andrew McIlhenny, an executive vice president with Firstrust Financial Resources in Philadelphia.
Automatic enrollment jump-starts the employee’s retirement savings program, McIlhenny says.
According to a 401(k) benchmarking survey issued by Deloitte Consulting LLP, 42 percent of 436 companies examined use the automatic enrollment feature in their company retirement plans. This is an increase of nearly 100 percent from the previous survey, says Glenn Sulzer, senior pension law analyst with CCH, a tax law information company in Chicago.
Despite the savings benefits, participants should be mindful of how these plans affect their individual financial picture.
“A lesser-paid employee may not feel comfortable deferring even the minimum percentage of compensation,” says Sulzer.
For anyone saving for retirement, here are five things to know about automatic enrollment 401(k) plans.
- Contribution percentages often too low.
- Default investment choices not always best.
- Salary deferral may increase automatically.
- Penalty-free plan withdrawals sometimes allowed.
- Most normal 401(k) rules apply.
Contribution percentages often too low
Nothing is a substitute for educating yourself and planning for your retirement. That includes knowing how much of your money is being saved, and where it is going.
“Employees need to learn their automatic enrollment contribution percentage,” says Gregory Karp, author of “The 1-2-3 Money Plan.”
With these plans, default deferral rates are typically about 3 percent of compensation. That savings rate is better than nothing, but it’s probably not enough to help people reach their retirement goals, says Karp.
“The danger of keeping the default rate is that you may think it’s all you need to save, but what you may really need is to save 10 (percent) or 15 percent of your pay,” he says.
Karp adds that if your employer offers a 401(k) match, you may not get the maximum matching dollars if the default savings rate is too small.
Default investment choices not always best
Participants also need to understand where their money is being invested. Automatic enrollment contributions are typically placed in a default account, such as a life-cycle or target-date retirement fund. These plans are selected based on the participant’s age, or the expected number of years until their retirement.
In other plans, contributions are placed in short-term accounts, such as money market funds, that aren’t designed to offer aggressive returns.
Tom Ruggie, president of Ruggie Wealth Management in Tavares, Fla., says that default accounts usually represent a one-size-fits-all approach that isn’t always good for the participant.
“Different employees have different risk tolerances and retirement goals,” he says. “It’s ridiculous to assume we need to give them the exact same accounts just because of their age.”
Ruggie suggests employees allocate their funds to specific retirement accounts that help them meet their goals. In other words, they should “opt in” with their retirement planning choices and actively decide where their money should be invested.
Salary deferral may increase automatically
Some automatic enrollment plans have step-up provisions that regularly increase deferral percentages, with the goal of helping employees increase their retirement savings over time, says Sulzer.
These salary-deferral increases usually occur around the same time an employee receives a cost-of-living raise, says Karp. Under most arrangements, the savings rate cannot exceed 10 percent of compensation in any year.
If your company is putting a freeze on raises this year, ask if your 401(k) plan will freeze automatic percentage increases, too. Otherwise, you could be deferring a bigger chunk of your paycheck into your 401(k) if the deferral percentage automatically increases.
Any time a major change is made to a plan, the employee should be notified.
Penalty-free plan withdrawals sometimes allowed
Some employees may start a job without realizing that a portion of their income will be placed in an automatic 401(k). If you discover such deferrals after the fact, you may still be able to halt future contributions and have any previous salary deferrals “refunded” back to you, says Sulzer.
Generally, this withdrawal election must be made within 90 days after the date of the first automatic contribution. Not everyone has the right to this type of refund, though.
“An employer is not required to include the withdrawal provision in the plan,” Sulzer says.
Other employers may offer a shorter time frame — such as 30 days — to make the withdrawal election.
Employees who elect to withdraw their money will owe income tax on the withdrawn amount, but they won’t receive the 10 percent penalty otherwise associated with early 401(k) withdrawals.
Most normal 401(k) rules apply
Contributions made to an automatic enrollment 401(k) generally follow the same rules as those of regular 401(k) contributions. These rules include:
- Early withdrawal penalties. In most cases, any withdrawal a participant makes before age 59½ is considered a distribution, which is subject to income tax as well as an additional 10 percent penalty tax. There are exceptions for a hardship withdrawal, but for most savers, the money needs to stay in the retirement account.
- Annual deferral and contribution limits. Depending on age and income, there’s a maximum amount of money that can be contributed to a 401(k). The general contribution limits for 2009 are $16,500 ($22,000 if you’re age 50 or older), although exceptions apply in some cases.
- Vesting. Employees cannot be required to forfeit any money they’ve saved through their own salary deferrals. However, employer contributions are usually vested according to the plan’s vesting schedule.
- Eligibility for the saver’s credit. This incentive, officially known as the Retirement Savings Contributions Credit, offers a credit between 10 percent and 50 percent of the amount put into a qualified retirement plan, subject to income limits.
To qualify for the credit, adjusted gross income, or AGI, for 2009 must not be higher than $53,000 if married filing jointly, $39,750 if filing as head of household and $26,500 if single.
For more information on these and other 401(k) rules, visit the IRS Web site for details.