State based auto-IRA programs continue to pick up steam, and may soon become prominent features of the retirement security landscape. Granted, there are a number of legal and logistical issues which need to be resolved before they can be fully implemented, but things are moving quickly.

So it is timely to discuss participant protections under these programs. A successful program must necessarily incorporate ways to protect employee deposits. The holding of employee deposits are not much of a concern, as employee deposits will be held in IRAs protected by highly regulated, commercial custody companies-as in any IRA program.  The real challenge will be the protection of employees’ payroll based deposits in getting to the IRA.  Any payroll based deposit program is subject to the vagaries of an employer’s cash flow, and this will be a particularly acute problem in the small employer marketplace (which just happens to be the target market of the state auto-IRA efforts).

States, however, resist the application of ERISA (and its attendant protections) to their auto-IRA arrangements. It is generally believed in the States that the burdens imposed by full fledged ERISA regulation would make auto-IRA virtually impossible to implement, and would be their death knell.  The DOL has pledged its support in finding a workable solution to this problem, and it has a proposed reg pending at OMB.

Does this mean that auto-IRA participants then would be left unprotected if ERISA doesn’t apply? Actually, I think not. There is a variety of state law criminal and civil causes of actions which can be taken against bad acting employers who don’t make timely deposit of auto-IRA. But, almost surprisingly, there is the possibility that the DOL and the IRS still may have jurisdiction over these deposits under (of all things) the Tax Code’s prohibited transaction rules-even if ERISA does not apply.

This is how it may work:  IRAs are subject to the prohibited transaction rules under Code Section 4975.  This shouldn’t concern an employer who timely deposits auto-IRA contributions to the custodian. At some point, however, it may be possible that an employer who delays making the IRA deposit might be will be actually be deemed to be holding an IRA asset- under the same rules that an employer holding onto 401(k) deposits for too long will be deemed to be impermissably holding onto plan assets. Why? because the DOL has jurisdiction over the prohibited transaction rules (even those under Tax Code Section 4975), and there really doesn’t appear to be any basis for a  legal distinction under its rules between holding on to 401(k) deposits for too long and holding on to IRA deposits for too long.

If the the employer is still holding on to IRA payroll deduction at the time it becomes an IRA asset,  the employer then would become become a custodian of the IRA asset.  This, in turn, makes the employer a “disqualified person” under 4975, and makes it liable for the prohibited transaction taxes for using those late deposits for its own purposes.

Yes, this is strange territory, and there will be those who will reasonably disagree with whether or not the PT rules should apply in this manner. But it is also a reasonable position, and one which lends an important element of ERISA-like protection without some of the unnecessary burdens.