Since 1997, nonprofit entities have been able to establish either a 403(b) plan or a 401(k) plan for their employees. There are distinct differences between these two types of plans that employers should consider before deciding which plan is best suited for their organization.
One distinct advantage 403(b) plans have over 401(k) programs is that employee salary deferral contributions are not subject to nondiscrimination testing. Section 401(k) plan salary deferrals must be tested on an annual basis to determine whether the contributions favored the highly paid employees, based on standards defined under the Internal Revenue Code (IRC). The Section 403(b) plan exemption from testing allows highly paid participants to make contributions during the year without concern that any of their salary deferrals will be returned to them due to failed nondiscrimination testing. This is an important consideration in many nonprofit organizations where there may be a small number of highly paid employees that would have a negative impact on nondiscrimination testing in a Section 401(k) plan.
In exchange for being exempted from nondiscrimination testing, Section 403(b) plans must allow for “universal availability,” which opens up the plan to practically all of the organization’s employees. An important advantage of Section 401(k) plans is the ability to exclude certain classes of employees and to impose eligibility requirements on new employees. Nonprofits with high turnover or with a segment of employee populations they want to exclude from benefits would likely find more flexibility in a Section 401(k) arrangement.
Some Section 403(b) plans sponsored by a nonprofit organization can qualify for an exemption from the regulations and rules of the Employee Retirement Income Security Act (ERISA), including the annual Form 5500 filing requirements. Section 401(k) plans are not exempt from the regulations and rules of ERISA.
Another key differentiator between these plans is their funding vehicles and investment options. Section 403(b) plans are invested through variable annuity contracts or custodial accounts that invest in mutual funds, which have traditionally been serviced through large insurance companies. Section 401(k) plans are open to any type of investment vehicle, although they are predominantly invested in mutual funds. Section 401(k) plan funding vehicles range from individual brokerage accounts to annuity contracts to pooled investment accounts.
The chart below summarizes the key differences between the two plans and is only a brief summary of the differences in these plans authorized by two distinct sections of the IRC.
For an analysis of the best program for your organization, please contact Richard Green at rgreen@windes.com or toll free at 844.4WINDES.
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