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Adding Auto Escalation to your 401(K) Retirement Plan

07/27/2017  |  By: Janet Neighbors, CPA, Senior Manager, Audit

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Want to increase participation in your 401(k) plan and help employees build their nest egg for retirement?

If you don’t have it already, consider amending your plan document to include auto enrollment with an auto escalation feature.  This enables employers/plan sponsors to enroll employees in their 401(k) plan once they have met the eligibility requirements, and automatically deduct elective deferrals from an employee’s wages unless the employee makes an election not to contribute or to contribute a different amount.  The employee’s deferral rate may then be automatically escalated annually until a set deferral rate is reached.  Employers typically begin at a deferral rate of 2 or 3 percent and annually increase it by 1% each year until they achieve a set deferral rate of 6 or 10 percent of their compensation. 

An additional benefit of auto enrollment with auto escalation is that it helps plans pass certain nondiscrimination testing.  This testing is done annually to ensure that highly compensated employees are not deferring more, or having more contributions credited on their behalf, than non-highly compensated employees.

While an initial deferral rate of 2% does not significantly impact an employee’s take home pay, it does, however, instill a good habit of saving that not all young people start at the onset of their careers.  As employees’ wages increase, the increase in deferral rate by 1% is negligible to their paycheck, but helps to build a larger nest egg at retirement.  While financial experts would advise at least a 10% savings rate annually, this arrangement gets employees on their way.  Any matching contributions made by the employer only improves the outcome.  Thanks to compounding and investment returns, the earlier and more consistently younger workers save for retirement, the lower the percentage of income they need to save over time.