From Auto-enroll to Spending Your Retirement Savings: New and Continuing 401(k) Rules Affect Workers Young and Old

(RIVERWOODS, ILL., January 2008) – Whether you are a younger worker who has not given retirement savings a first thought or an older worker looking to start spending your nest egg, tax rules governing 401(k) accounts will likely impact your plans, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and pension information, software and services (CCHGroup.com).

“401(k) plans have become the predominant retirement plan vehicle , as defined benefit pension plans continue to diminish. However, the challenge to employers and policy makers has been to not only increase participation in 401(k)s , but to encourage employees to contribute an amount that will ensure adequate retirement savings ,” said CCH Pension Law Analyst Glenn Sulzer, JD.

Automatic enrollment of employees in 401(k) plans is expected to help push participation rates significantly higher, especially among younger and low-wage workers who are often less likely to participate in a plan or change employment before realizing significant savings under a plan. The IRS has approved automatic enrollment arrangements for several years. However, 2008 is the year auto-enrollment is expected to take off , Sulzer notes, because new guidelines and clarifications have been issued to help employers take advantage of statutory incentives for adopting automatic enrollment .

Jump Starting Automatic Enrollment

While companies have had the ability to implement automatic enrollment plans for some time, they were hesitant to fully implement the programs because of fears of being held accountable for underperforming investments to which employee contributions were allocated. However, the Department of Labor (DOL) has issued guidelines ensuring companies they won’t be liable if funds in an auto-enrolled employee’s account lose value, so long as the investment defaults are age or retirement-date targeted.

Under automatic enrollment, an employer notifies an employee when he has been automatically enrolled. This notice must disclose how much of the employee’s wage is being deferred, the amount of the company’s matching program, if any, and how the funds are being invested . The notice must also detail the employee’s rights under the arrangement, which include the power to change the amount that is deferred, allocate deferrals to different investments within the 401(k) or opt out of the plan.

“Employees are given the chance to opt out, but an underlying assumption is that if inertia kept employees from participating in the company’s 401(k) program in the first place, inertia may also keep employees from opting out,” said Sulzer. “Auto-enrollment may also introduce employees to the benefits of tax-deferred savings and provide the incentive they need to start saving for their retirement.”

An added benefit for employers that implement automatic enrollment is that it will make it easier for them to meet the nondiscrimination tests applicable to 401(k) plans that basically prevent employers from allowing highly compensated employees to contribute more to the plan or receive more employer contributions than lower compensated employees. By adopting a qualified automatic enrollment arrangement, an employer will enable highly compensated employees (those with a 5 percent or more ownership stake in the company or those earning more than $105,000 in 2008) to contribute more of their income to a company 401(k) plan.

For employees, the obvious benefit of sticking with a 401(k) plan is the ability to contribute pre-tax dollars toward their retirement. As was the case for 2007, for 2008, employees can contribute up to $15,500 to a 401(k) plan and $5,000 more as a catch-up contribution if they are 50 years of age or older. However, most individuals do not contribute the maximum amount and any auto-enrollment program will likely be far less than the maximum.

“Ideally, you should contribute as much as your circumstances allow, and if your employer offers a matching contribution, you should try to contribute at least up to what can be matched , as otherwise you’re leaving money on the table that could go toward funding your retirement,” said Sulzer.

Saver’s Credit Could be Extra Bonus of Auto-Enrollment

Some employees who are automatically enrolled in their company’s 401(k) plan may also find they are now eligible to take advantage of the Saver’s Credit. This nonrefundable tax credit allows participants with an annual adjusted gross income (AGI) below specified threshold levels to use elective contributions to the plan (up to $2,000) to reduce their federal income tax on a dollar-for-dollar basis. The credit is available (up to $1,000 per year for each eligible individual) to married couples filing jointly whose AGI in 2008 is $53,000 ($52,000 in 2007) or less , head of household filers with an AGI of $39,750 ($39,000 in 2007) or less and single filers whose income is $26,500 ($26,000 in 2007) or less.

Depending on income, the credit ranges from 10 percent to 50 percent with lower income taxpayers being eligible for a higher credit. For example, a married individual filing jointly with a combined AGI of $32,000 making a $2,000 contribution to a 401(k) plan could be eligible for a 50-percent credit, or $1,000 in 2008. By contrast, a married individual filing jointly with a combined AGI of $50,000 making a $2,000 contribution could be eligible for a 10-percent credit or $200 for this year.

The Saver’s Credit also applies to contributions to IRAs, Roth IRAs, SIMPLE plans and other qualified retirement plans. However, it is not an automatic credit. Eligible individuals need to be aware of the requirements and use IRS Form 8880 to claim the credit.

Consequences of Early Withdrawal

With just a few exceptions, any withdrawal prior to retirement from a 401(k) plan is viewed as a distribution, which is subject to income tax as well as an additional 10-percent penalty tax if it is withdrawn before the individual turns 59½.

“It is not uncommon to find a worker who cashes out his 401(k) when leaving a job instead of either keeping it in his former employer’s 401(k) program or directly rolling it over into his new employer’s 401(k) plan, if allowed, or an IRA. Under such circumstances, the employee will not only experience the opportunity cost of not having income grow tax-free, but will also incur state and federal income taxes on the withdrawal and an additional 10-percent penalty,” noted Sulzer.

Individuals also can request hardship distributions from 401(k) plans. A hardship distribution may be authorized because of the employee’s immediate and heavy financial need , the distribution is necessary to satisfy the need and the distribution does not exceed the amount necessary to satisfy that need. Note, however, hardship distributions are generally included in the employee’s income and subject to the 10-percent penalty on early distributions.

Hardship distributions are authorized for medical expenses incurred by the employee, employee’s spouse, dependent or – under the Pension Protection Act – beneficiaries other than spouses and dependents, such as siblings or domestic partners. Other examples of expenses and circumstances justifying hardship distributions include : post-secondary tuition, costs associated with avoiding eviction or foreclosure, burial or funeral expenses or expenses for the repair of casualty damage to the employee’s principal residence.

A 401(k) plan also may authorize employees to borrow against their account balances. An employee is not subject to tax on the amount of the loan. However, the amount of the loan may not exceed the lesser of $50,000 or one-half of the present value of the participant’s account; the terms of the loan (other than principal residence loan) must require repayment within five years; and the loan must be amortized on a level basis with payment made no less frequently than quarterly. Note, refinancing does not generally qualify as a principal residence loan.

If an employee is in the military, a plan may (but is not required to) suspend an employee’s obligation to repay a loan during the period of the employee’s military service.

Minimizing Tax Impact in Retirement

As more individuals head into their retirement years, the challenge for many becomes how to effectively manage retirement savings. Individuals participating in traditional 401(k) plans are required to start taking distributions on April 1 of the calendar year following the year they reach age 70½ or they retire, whichever occurs later. Participants who also are 5-percent owners in the company with the 401(k) cannot hold off on taking a distribution by continuing to work; rather they are required to begin taking distributions on April 1 of the calendar year after they turn 70½. Individuals can either take the entire lump sum at that point or begin receiving payments over a period of time designed not to exceed the lifetime of the individual or their beneficiary, with IRS regulations defining the required minimum distribution pursuant to a Uniform Lifetime Table or Single Life Table.

Employees will be subject to income tax on the amount of their distributions. Sulzer cautions from a tax perspective, employees should exercise restraint in taking distributions greatly in excess of the amount necessary to sustain their lifestyle.

About CCH, a Wolters Kluwer business

CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals and their clients since 1913. Among its market-leading products are The ProSystem fx® Office, CorpSystem™, CCH® Tax Research NetWork™, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill.

Wolters Kluwer is a leading global information services and publishing company. The company provides products and services for professionals in the health, tax, accounting, corporate, financial services, legal and regulatory sectors. Wolters Kluwer has 2006 annual revenues of €3.4 billion, employs approximately 18,450 people worldwide and maintains operations across Europe, North America, and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices. For more information, visit www.wolterskluwer.com.

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