Choosing between a
401(k) and a 403(b)
How to decide whether a 401(k) or a 403(b) is the best fit for your organization.
Although 401(k) plans are currently the most well-known type of retirement plan, 403(b) plans have been around much longer. 403(b) plans were introduced in 1958 to supplement pensions for teachers. The 401(k) wasn’t possible until 20 years later, when Congress passed the Revenue Act of 1978. Since that time, the 401(k) has grown more and more popular. Why are there more 401(k) plans than 403(b) plans? Any company can have a 401(k) plan, but only certain organizations are allowed to offer a 403(b). Only 501(c)(3) tax-exempt organizations, public schools and churches can have a 403(b) plan. If you are one of these organizations that has a choice between using a 401(k) or a 403(b), how do you decide which type of plan is the best fit for your organization? Here are some important things you should consider when making that decision.
Nondiscrimination testing is an area where 403(b) plans have a huge advantage. Testing is something that is performed annually to ensure that retirement plans benefit all employees. 403(b) plans are never subject to the Actual Deferral Percentage (ADP) test or the Top-Heavy test. However, a 401(k) could be subject to both of these tests. The ADP test compares the average deferral rates of the highly compensated employees (HCEs) to the average deferral rates of the non-highly compensated employees (NHCEs). If the HCEs are participating at a much higher rate than the NHCEs, which is often the case, the HCEs might be restricted regarding the amount they can contribute into their 401(k). The Top-Heavy test looks at whether 60% of total plan assets are allocated to the accounts of key employees. Plans covering a few employees are more likely to be top-heavy than those covering a large number of employees. Plans can be designed to avoid nondiscrimination testing. However, if nondiscrimination testing is required, a 403(b) plan will have an easier time passing testing than a 401(k) plan, because they can skip the ADP and Top-Heavy tests.
Some 403(b) plans are exempt from ERISA, which makes them easier to administer and lowers costs for the employer. A 403(b) plan can be a Non-ERISA plan if it is sponsored by a government or church or if the employer does not contribute. 401(k) plans are always subject to ERISA, which is a federal law that protects participants by requiring employers to file an annual IRS form 5500, provide annual disclosures to employees, and perform an annual audit of the plan if they have more than 100 participants.
It is easier to exclude part-time employees in a 403(b) plan than a 401(k) plan, due to the SECURE Act that was passed in late 2019. Now employers with a 401(k) plan are required to allow long-term part-time employees to make elective deferrals. Part-time employees will be eligible to participate in a 401(k) if they have completed at least 500 hours of service each year for three consecutive years and are at least age 21 by the last day of the same three-year period. This new provision does not apply to 403(b) plans.
Service Requirements for Employee Deferrals
401(k) plans can require employees to work up to one year of service and attain age 21 before they are allowed to save their own contributions in the plan. However, 403(b) plans must satisfy the universal availability requirement regarding employee contributions. Therefore, all employees must be allowed to save their own money in a 403(b) plan, no matter how short a time they have worked with the organization, with a few limited exceptions like part-time employees.
Additional Investment Options
In a 403(b) plan, the only allowed investment options are mutual funds and annuities. In a 401(k) you can also invest in individual stocks, bonds, and ETFs, often through a self-directed brokerage account. Even with these additional choices, mutual funds are still the most common type of investment option offered by a 401(k).
If you are a church, government, or a nonprofit who cannot contribute an employer contribution yet, the 403(b) maybe a better fit because you can be exempt from ERISA. Also, if you are a smaller organization or have employees that earn over the HCE limit (or hopefully will in the next few years), a 403(b) maybe better for nondiscrimination testing. However, there are also a few advantages to a 401(k), such as allowing a service requirement for employee contributions and additional investment options. If you are one of the lucky organizations that can utilize a 403(b) or a 401(k), you have two excellent options.