403(b)s and 401(k)s share more similarities than they do differences, however the glaring difference is that 403(b)s are exclusive to nonprofit organizations.
Many think that nonprofits must utilize a 403(b) when choosing a retirement plan vehicle for their employees, but this is a commonly held misbelief. In fact, many nonprofit organizations have established 401(k)s in recent years. Why choose one over the other? Well, it depends on the goals of the organization!
Religious, charitable, education, scientific, and literary organizations described in IRC Sec. 501(c)(3), certain governmental employers and public school systems have been able to establish 403(b) plans for their employees. In 1996, the law changed to allow nonprofits to choose either the 403(b) or the 401(k), and depending on the objectives an organization is looking to achieve with their retirement plan, one may make more sense than the other. Here are a few key differences between the two types of plans:
- Unlike 401(k) plans, 403(b) plans are not subject to nondiscrimination testing requirements for salary deferral contributions (Actual Deferral Percentage Test, or ADP Test). The nondiscrimination testing rules that apply to 401(k) plans sometimes require that salary deferral contributions be returned to highly compensated employees due to a failing ADP Test. This does not happen with 403(b) plans.
- The Actual Contribution Test, or ACP Test, still applies regardless, unless the 403(b) provides for a safe harbor contribution similar to those applicable to 401(k)s.
- Of course, if the nonprofit organization does not retain any employees who are deemed to be a Highly Compensated Employee, neither of these tests would apply regardless.
- 403(b) plans must follow the “universal availability” rule for eligibility to make salary deferral contributions, meaning that if an employer permits one employee to defer salary into a 403(b) plan, they must extend the offer to all employees, with limited exceptions.
- Annual limits are the same for both a 401(k) plan and a 403(b) plan, except that the 403(b) plan may elect an additional form of catch-up contributions for participants who have 15 years of service, giving participants more flexibility.
Some nonprofit organizations have in fact established 401(k) plans in recent years, as the 401(k) is more well-known to their employees. However, the choice still exists! It is best to evaluate your organization’s retirement plan goals to determine which may be a better fit.