Internal Revenue Code Section 501(c)(3) organizations that sponsor an ERISA 403(b) plan may be faced with a decision of whether it should terminate or freeze its 403(b) plan and sponsor a 401(k) plan instead. Before making a decision, a plan sponsor should examine key plan features that would be lost if the current 403(b) plan were replaced with a 401(k) plan. This article will discuss a few advantages that an ERISA 403(b) plan has compared to a 401(k) plan; including fewer nondiscrimination testing requirements under the Internal Revenue Code (the Codeî=) and an opportunity for additional catch-up contributions.
Generally, the Code requires 401(k) and 403(b) plans that are subject to ERISA to perform nondiscrimination testing on an annual basis to ensure that the plan does not discriminate in favor of highly compensated employees (HCEs). Depending on the test, the HCEs could include owners, officers or other employees who earn over an annual dollar amount specified in the Code. As explained below, 403(b) plans, are exempt from two nondiscrimination tests that are required of 401(k) plans.
Actual Deferral Percentage (ADP) Test
Only a 401(k) plan is required to perform an annual ADP test. The ADP test must be satisfied to ensure that the amount of elective deferrals made to the plan does not discriminate in favor of HCEs. HCEs are generally employees who make at least $120,000 a year (as indexed for 2017). The ADP test compares amounts deferred by HCEs to the 401(k) to amounts of non-HCEs. If the 401(k) plan fails the ADP test, then the plan sponsor has several options of correcting the failure.
To correct a failed ADP test, the plan must (1) distribute the excess deferral to the HCEs; or (2) the plan sponsor must make additional contributions to the plan on behalf of the non-HCEs. Each of these options present issues. If a 401(k) plan sponsor chooses to distribute the HCEs excess deferral amounts, it limits the amount that HCEs can contribute to the plan and have such contributions grow on a tax-deferred basis. This issue is compounded if HCEs deferrals are limited over multiple years. If a 401(k) plan sponsor chooses to correct a failed ADP test by making additional contributions on behalf of non-HCEs so that excesses do not need to be returned to HCEs, then the correction method comes at a cost to the plan sponsor.
By contrast, a 403(b) plan is not required to perform an annual ADP test. As a result, 403(b) plan sponsors do not have to worry about limiting contributions made to the plan by HCEs, or costs associated with correcting a failed ADP test.
Code Section 416 Top-Heavy Testing
Another nondiscrimination test that is required of 401(k) plans, but not of 403(b) plans is the Code Section 416 Top-Heavy test. Pursuant to the Top-Heavy test, if more than 60 percent of the benefits of a 401(k) plan are attributable to key employees, the plan is considered ìtop-heavy.î In general, key employees are employees that own at least 5% of the sponsoring entity or an officer who makes over a certain dollar amount on an annual basis. If the test identifies that a plan is top-heavy, then the plan sponsor is required to provide minimum contributions to non-key employees. In addition, based on the planís vesting schedule, the plan may be required to provide more rapid vesting. The lack of a top-heavy testing requirement relieves 403(b) plan sponsors from the potential burden of making additional contributions to the plan and/or implementing a faster vesting schedule.
Additional Contributions ó 403(b) 15 Years of Service Special Catch-up
Both a 403(b) plan and 401(k) plans may provide for an Age 50+ catch-up. This Age 50+ catch-up feature permits plan participants who are at least age 50 in a calendar year to contribute an additional amount ($6,000 as indexed for 2017). A 403(b) plan, however, has an additional special catch-up provision. This special catch-up is commonly referred to as the ì15-years of service catch-up.î This permissive plan feature allows employees of public schools and certain 501(c)(3) organizations who have at least 15 years of service with their employer, and have under contributed in past years, to make additional contributions to the plan. The 15-years of service catch-up limit is $3,000 per year with a lifetime maximum of $15,000. With this additional catch-up contribution, plan participants can save even more for their retirement!
These are only a few of the differences between a 401(k) plan and a 403(b) plan that plan sponsors may wish to consider. If the goal of a 501(c)(3) retirement plan sponsor is to minimize testing requirements and to allow plan participants to contribute the maximum amount permitted by the IRS, a 403(b) plan may likely be the clear choice. As always, a 501(c)(3) plan sponsor should consider all plan features, as well as the goals of their plan participants when making a determination as to which type of retirement plan is best for their organization.
Lynn Knight, CEBS, is a Senior Advanced Consultant at Voya Financial and a member of Technical Services for Tax-Exempt Markets there as well. Lynn has worked extensively in the retirement plan field for a broad spectrum of defined contribution plans, including 403(b), 401(k) and 457(b) plans, both at law firms and with retirement service providers. She also is a member of the NTSA Communications Committee.
This material was created to provide accurate information on the subjects covered. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. These materials are not intended to be used to avoid tax penalties, and were prepared to support the promotion or marketing of the matters addressed in this document. The taxpayer should seek advice from an independent tax advisor.
*Lynn is not a practicing attorney for Voya Financial.
Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA or its members.