Choosing between a Sec. 401(k) or 403(b) Plan

Since 1997, Sec. 501(c)(3) organizations (e.g., charitable, religious and educational groups) have been able to adopt and sponsor Sec. 401(k) plans. In addition, Sec. 501(c)(3) organizations are the only tax-exempt entities that can provide Sec. 403(b) plans to their employees.

At first glance, Secs. 401(k) and 403(b) plans seem comparable; both plans are cash-or-deferred arrangements, under which an employee can elect to have pretax payments made to the plan rather than receive the amounts as currently taxable compensation. Also, each plan limits employees' pretax elections to $11,000 in 2002 (Sec. 402(g)), and overall 2002 annual additions to the lesser of $40,000 or 100% of eligible compensation (Sec. 415(c)). Aside from these similarities, however, the two arrangements have significant differences that employers should consider when designing a Sec. 501(c)(3) organization's deferred compensation package.

A Sec. 401(k) plan is a qualified plan subject to ERISA. As such, it must comply with the many written plan document, fiduciary, administrative, reporting and disclosure requirements imposed on qualified plans. Sec. 403(b) plans, however, are not qualified within the meaning of Sec. 401(a) and can avoid ERISA coverage; see Department of Labor Regs. Section 29 CFR 2510.3-2(f).

A non-ERISA Sec. 403(b) plan must meet two general requirements. First, it must limit contributions to voluntary employee salary reductions; employers cannot fund benefits. Second, the employer's involvement in the plan is extremely restricted. Its role is to provide general information about the plan and withhold employee salary reductions and forward them to the plan. Although the salary reductions have a limit, each employee—not employer—is responsible for ensuring that annual contributions do not exceed the allowable amounts.

Sec. 501(c)(3) organizations have four choices for elective deferral arrangements.

1. Stand-alone non-ERISA Sec. 403(b) plan: If an employer is unable to fund a retirement benefit for its employees, it could provide a plan that accepts pretax, employee salary-reduction contributions. Such arrangements have many advantages:

• An employer avoids virtually all administrative responsibilities and costs.
• Sec. 403(b) plans are exempt from the actual-deferral-percentage test imposed on Sec. 401(k) plans, so the participation of nonhighly compensated employees (NHCEs) does not limit the contributions of highly compensated employees (HCEs).
• Top-heavy testing does not apply to Sec. 403(b) plans, so the employer never has to make a minimum contribution on behalf of its NHCEs.
• Compliance problems, if any, are generally limited to individual participants and do not place the entire plan at risk.

2. Qualified plan coupled with a non-ERISA Sec. 403(b) plan: Employers can fund retirement-plan contributions made to a qualified plan (e.g., a money-purchase pension plan) that parallels a non-ERISA Sec. 403(b) arrangement. The employer deposits employees' voluntary salary-reduction contributions to a Sec. 403(b) plan and makes employer contributions to the qualified plan. The Sec. 403(b) plan retains all of the advantages discussed. Additionally, for purposes of the Sec. 415 limit, contributions to a non-ERISA Sec. 403(b) plan are generally not aggregated with contributions to employer-sponsored qualified plans (Regs. Sec. 1.415-8(d)(1) and (2)). Consequently, a participant may receive employer contributions up to the Sec. 415 limit in the employer's qualified plan and make additional contributions up to a separate Sec. 415 limit in the Sec. 403(b) plan. This higher, overall contribution maximum is extremely attractive for an organization's executives and other HCEs.

3. ERISA Sec. 403(b) plan: When an organization makes employer contributions to a Sec. 403(b) plan, the plan becomes fully subject to ERISA. Such an arrangement is extremely disadvantageous:

• The employer assumes all of the obligations and responsibilities imposed on an ERISA-plan sponsor and must fully administer the plan.
• The plan has one Sec. 415 limit to cover both the employer contribution and employee salary reductions; it loses the greater overall contributions permitted when a Sec. 403(b) and qualified plan co-exist.
• The compliance levels for Sec. 403(b) plans are undesirable; it is difficult to hire a third-party administrator to perform the testing and compliance requirements, and the IRS does not provide a determination letter to give the plan a "stamp of approval."

Practitioners should make employers that sponsor this plan type aware of the other choices available.

4. Sec. 401(k) plan. Certain Sec. 501(c)(3) organizations insist on making both their employer contribution and the pretax, elective contributions to a single plan, usually because they base their contributions on matches of employee elective deferrals. Such an employer benefits from sponsoring a Sec. 401(k) plan instead of an ERISA Sec. 403(b) arrangement:

• Support services for administering a qualified plan are better and include the availability of third-party administrative services and an IRS determination letter.
• A Sec. 401(k) plan offers investment choices beyond the annuity contracts and mutual funds available under Sec. 403(b).

If an organization chooses to forgo the advantages of a Sec. 403(b) plan, it should at least enjoy the benefits of a qualified plan.

Sec. 501(c)(3) organizations have unique opportunities for designing tax-deferred retirement benefit programs. Given the existing availability of Sec. 403(b) plans to these employers, they should consider such plans for their benefit programs.

From Lori Friedman, CPA, APA, MSA, Washington, DC