401(k) versus 403(b)

Many organizations are eligible to have either a 401(k) or a 403(b) plan. So what's the difference? Which is better? The answer all depends on your organization's characteristics and the goals you have for the plan. Here is a brief overview of some of the main differences and a few questions that you should ask:

Eligibility

Unique to the 403(b) plan is the Universal Availability requirement, which means that all employees (with limited exceptions) MUST be permitted to make elective deferrals from date of hire. Downside: you have to let everyone in the plan. With a 401(k), you can restrict eligibility, subject to nondiscrimination testing requirements.

Questions to ask: Who are we trying to cover with this plan? How will that affect our budget? How will we track that we really did offer the plan to ALL employees (part-time/seasonal too!) and who declined to participate?

Non-Discrimination Testing

It's not necessary to test 403(b) salary deferral employee contributions. As a result, highly compensated employees (defined in 2013 as those who earned $115,000+) have no additional limitations imposed on their ability to save, other than the overall IRS 402(g) limitations. In 401(k) plans, you have to test the plan for non-discrimination. Among other things, if the spread between average deferral amounts of non-highly compensated employees and highly compensated is too wide, the plan will fail testing and highly compensated employees may not be able to max out their contributions for the year. [Note: 403b do have to test employer contributions.]

Questions to ask: What do we anticipate the participation to be? How much might employees contribute on average? If we choose the 401k, are we willing to make an employer contribution so that we can forgo testing (safe-harbor plan design)? Do we have highly compensated employees that would be upset if they were capped? Is it better or cheaper to have them covered by a non-qualified deferred compensation plan instead?

Contributions

Both plan types allow an employee to contribute up to the 402(g) Limits (for 2014: $17,500 and Age 50+ Catch-up: additional $5,500) except, of course, if the 401(k) fails the testing mentioned above. Unique to 403(b) plans and a holdover from former days is the 15-year catch-up election. This is where a 403(b) plan can permit employees with 15 years or more of service who satisfy additional requirements to defer up to an extra $3,000 over and above the 402(g) limit. (Warning: This election is complicated to calculate.)

Questions to ask:  Do we have any long term employees (15 years or more of service) who want to save extra in their plan above the normal IRS limit? Do we have the resources to track this?

Types of Allowable Investments

In this day and age of choices everywhere, I'm not sure that this is as relevant as it once was, but it's worth mentioning. IRC §403(b)(1) permits investments in annuities and IRC §403(b)(7) permits investments in custodial accounts invested exclusively in shares of “regulated investment companies” as defined in IRC §851(a).  401(k) plans are not as restricted and can invest in mutual funds, individual securities, ETFs, collective trusts, separate accounts, etc. 401(k) plans can also have guaranteed withdrawal minimum programs and group annuities to allow for many of the same types of withdrawal and annuitizing options that only 403(b) plans used to have access to.

Questions to ask: If we use a 403(b), will it be through individual contracts or a group plan? Do we need access to certain types of investments? How do fees affect these options and ultimately the employee's investment return? Do we have a savvy workforce that may use self-directed brokerage accounts? What kinds of guarantees do we need to have associated with the plan? Is a group annuity 401(k) plan a better way to achieve favorable pricing? What types of investment "problems" are we trying to solve?

Hopefully this gives you an overview of important things to consider when choosing between a 401(k) and 403(b). If you want some assistance in sorting out what fits your organization best, drop us a line on the Contact Us page or sign up to receive juicy tid-bits like this one in your inbox!