Whether you’re a plan sponsor, financial advisor or CPA, or other service provider in the industry, we know that there are many differences (and similarities) between 401(k) and 403(b) plans. And when it comes to offering a retirement plan, only public schools and 501(c)(3) organizations specifically can choose from the two. This is not the case for corporations, which by law cannot sponsor 403(b) plans. Choices can bring about confusion. So, what’s the best retirement plan option for tax-exempt organizations? Answer: It depends. Generally, a 403(b) is a better choice for not-for-profits, but not always. Let’s discuss a few key differences to get a better understanding.
Non-discrimination Testing
403(b) plans are not required to perform many of the annual nondiscrimination testing that are required for 401(k) plans. More specifically, 403(b) plans are not required to perform the Average Deferral Percentage (ADP) test, which tests salary deferrals of non-highly compensated employees with salary deferrals of highly-compensated employees. For 2022, highly-compensated employees are those earning over $135,000. Ultimately, not having to perform the ADP test mitigates the risk of any highly-compensated employee getting corrective refunds as a result of a failing test.
Eligibility Requirements
401(k) plans can be more restrictive when it comes to choosing when employees can become eligible for the plan. However, that’s not the case for 403(b) plans, especially when it comes to employee contributions. While a 401(k) plan can elect up to 1 year waiting period before a new hire becomes eligible, a 403(b) must allow employees to participate immediately upon hiring. This rule is dubbed “Universal Availability.” And because of this Universal Availability rule (that is, allowing employees to be plan-eligible immediately upon hire), 403(b) plans get a free pass on the ADP test. Hey, there’s no free lunch.
Investment Choices
401(k) plans have almost unlimited range of investments (stocks, bonds, real estate, etc.) it can offer. But 403(b) plans are limited to annuity and mutual funds only. So, if employees of a 501(c)(3) have dire interest to invest in say, real estate or stocks, this could only be done through a 401(k) plan.
Final Words
It’s no surprise that most 501(c)(3) organizations go with a 403(b) plan. That makes sense considering some of the unique advantages available to only not-for-profit organizations. However, it’s not unusual for 501(c)(3) organizations to offer a 401(k) plan, especially healthcare organizations where doctor employees may want to invest in more exotic investments. Whether your organization already offers a retirement plan or you’re looking to sponsor one, it is recommended that you do due diligence as well as weigh pros and cons of all available optionsT
This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company’s benefits representative for rules specific to your plan.
About the Author
A 15-year veteran in all aspects of workplace retirement plan benefits program, Mizan J. Rahman is on a mission to help hard-working Americans enjoy a meaningful financial future. He specializes in the compliance, administration, design, and legal documentation of 401(k), 403(b), and 457(b) plans. Mizan provides high-level, personalized consulting to small businesses and not-for-profit organizations. One of the select few to have been awarded Enrolled Retirement Plan Agent (“ERPA”) by the Internal Revenue Service, Mizan regularly represents clients in front of DOL and IRS during audits.
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