Whether you are a plan sponsor, financial advisor, CPA, or ERISA attorney, you know that section 401(k) and 403(b) plans are different – and similar in many ways. Take for example “Universal Availability” (more on that later) rule which applies to 403(b) but not to 401(k), or that investments permitted in a 403(b) plan are only custodial mutual funds and annuities while no investment restrictions to a 401(k). Let’s put some of these differences and similarities in perspective.
Eligible Employer
In a nutshell, a 401(k) can be established by corporations, self-employed, sole proprietorships, partnerships, and tax-exempt organizations. And a 403(b) can be established by public education employers and 501(c)(3) organizations.
Eligibility Rules
Rules for contribution eligibility for each plan type are different depending on contribution type. For employer contributions, eligibility restrictions are same for both types of plans: employer can require an employee to complete one year of service before he or she becomes eligible for matching, for example. However, the rules for employee contributions – pre-tax deferral and Roth – are different. Specifically, “Universal Availability” rules apply to 403(b) plans, meaning that nonprofits must allow ALL employees (unless excluded) to start contributing on their date of hire. A 401(k), on the other hand, can require up to one year of service for both employee and/or employer contribution.
Plan Document Requirements
Both 401(k) and 403(b) must have written document. Prior to 2009, there was confusion about whether certain 403(b) needs a document; that has changed. Starting in 2009, all 403(b)s must have written document. However, no pre-approved document exists for 403(b), at least not yet. We know IRS is working on pre-approved documents and the industry anxiously awaits. If your 403(b) is audited by DOL and the agent requests copy of the IRS Determination Letter, tell him or her nicely, “You need to give us one.” As for 401(k), written document was always required and pre-approved documents have been always available.
Contribution Limits
Contribution limits for both plan types is similar, except for the special 15 year of service catch-up available under 403(b). For 2017, a 401(k) or a 403(b) participant can contribute a total of $18,000. If the employee is 50 and older, he or she can contribute additional “catchup” of $6,000. Both pre-tax deferral and Roth deferral available under both plan types. While these are the deferral limit, the maximum individual annual limit is $54,000, or $60,000 if age 50 and older. So if a 45-year-old participant defers $18,000, the employer could potentially contribute an additional $36,000, to get to the $54,000 maximum for the year. Specific to 403(b) plan, a participant can defer an additional $3,000, a feature called “15-Year Catchup,” each year up to maximum life-time limit of $15,000. This is an optional feature. The calculation and record-keeping is complex. This special catch-up is not available to 401(k) plan.
Investments
401(k) participants can choose any investment instruments (individual stocks, bonds, mutual funds), while 403(b) participants are limited to only annuity contracts purchased from insurance company and custodial accounts invested solely in mutual funds.
Distribution Rules
Restrictions on distributions are identical for both plans. Distribution permitted only after termination of employment, death, or disability. In-service distribution is permitted if allowed by the plan. The 10% early withdrawal penalty applies.
Nondiscrimination Testing
Unlike 401(k) plans, Actual Deferral Percentage (ADP) and top-heavy testing do not apply to 403(b) plans. Not being subject to ADP testing means that highly-compensated employees are not restricted on how much they can contribute. No ADP and no top-heavy under a 403(b) is a huge advantage to 403(b) plans!
Form 5000 Filing
Most 403(b) plans are required to file 5500 series form. Some 403(b)s can avoid ERISA coverage if certain conditions are met: (1) it is a deferral only plan (meaning no employer contributions) and (2) limited involvement from employer. All 401(k) plans are required to file Form 5500, with the exception to one-man plan with assets under $250,000. Finally, both 401(k) and 401k(b) plans require audit by Independent Qualified Public Accountant (IQPA) if plan is a large filer, with the exception of non-ERISA (b) plan.
Final Thoughts
It’ll be 10 years since IRS profoundly changed the 403(b) world with the issuance of the final 403(b) regulations which were targeted to make 403(b) plans like 401(k) plans. Although the goal has been successful thus far, much work is to be done. It can be quite challenging for plan sponsors to retain retirement plan as ERISA rules are complex and ever-changing; therefore, plan sponsors should seek guidance from experts in the industry with their retirement plans.
Mizan J. Rahman has over a decade of experience working with businesses and tax-exempt organizations. Expertise includes 401(a), 401(k), 403(b), and 457(b) plans.
