This is the first of a 3-part article comparing 401(k) and 403(b) plans from the perspective of the plan sponsor of a nonprofit organization.

When people think of qualified retirement plans, they generally think of 401(k)s. Nonprofit organizations, however, also have the choice of setting up a 403(b) plan.

A lot of plan sponsors go with 401(k) just because it’s what they’re used to; they have the instant name recognition that 403(b)s may lack. For this reason, a lot of plan sponsors assume that setting up a 401(k) retirement plan is the best option.

Upon digging deeper, however, this isn’t necessarily the case. In this post, we’ll go over some of the key differences between 401(k)s and 403(b)s, showing why, for most nonprofit organizations, setting up a 403(b) plan may be a better option than a 401(k).

Most fundamentally, the difference between 401(k) and 403(b) plans is who is eligible to use them. Whereas 401(k) plans are available to both for-profit and nonprofit entities, 403(b)s are offered only to 501(c)(3) non-profit organizations, religious institutions, public school systems, hospital service organizations, the Uniformed Services University of the Health Sciences, and public school systems organized by Native American tribal governments.

Still, at face value, 401(k) and 403(b) plans are very similar: they’re both tax-deferred retirement plans that allow their participants to set aside money for retirement. Both allow for annual deferral of $18,000 as well as the annual age 50 catch-up contribution of $6,000 per year. Also, the employer can offer their staff a matching contribution, invest in mutual funds, allow for loans, hardships and distributions, and so on.

Two key advantages of 403(b) plans

From the perspective of the plan sponsor, however, there are a handful of major distinctions between 401(k)s and 403(b)s, that a knowledgeable plan sponsor can take advantage of when designing their retirement plan.

  • All 401k plans must abide by ERISA law; however, this isn’t true for all 403(b) plans

Governmental employers, certain public schools, hospitals, and religious organizations are exempt from ERISA. In addition, 501(c)(3) nonprofits can also be exempt from ERISA as long as there’s no employer money going to the 403(b) and the employer maintains very limited involvement with the 403(b). In this case, the plan is considered a non-ERISA plan, meaning that it doesn’t have to deal with 5500 filings, discrimination testing, an annual audit, major plan document upkeep and is not subject to the strict fiduciary standards associated with ERISA plans. In the long run, this can save a plan sponsor — especially of a small nonprofit on a tight budget — a lot of time and money. There are several non-ERISA 403(b) products on the market that have very low or even no out-of-pocket annual fees to a plan sponsor and a good financial advisor who knows the market well can help identify them.

  • 401(k)s have two nondiscrimination testing requirements, whereas 403(b)s have only one

Nondiscrimination testing was implemented to make sure that lower- or mid-income workers in a given organization receive similar tax savings compared to high-income workers with respect to their retirement plans. To that end, highly compensated employees (HCEs) — those who earn more than $120,000 per year — and non-highly compensated employees (NHCEs) — those who earn less than $120,000 per year — must receive similar tax savings.

There are two broad categories of nondiscrimination tests required by the IRS: the ADP (Actual Deferral Percentage) test and the ACP (Actual Contribution Percentage). The ADP test compares the average salary deferral of HCEs to that of NHCEs. In order to pass the test, the ADP of HCEs must be within a certain spread of that of the NHCEs.

The rule of thumb is that this “spread” is two percentage points — so if NHCEs are deferring, on average, 4% of their salary, the HCE average cannot exceed 6%. However, it’s not that simple: the maximum spread depends on how much NHCEs are deferring, and is summarized below:

NHCE employee average                             HCE employee average

Less than 2%                                                  Cannot exceed NHCE average x 2

Between 2% and 8%                                       Cannot exceed NHCE average + 2

Greater than 8%                                             Cannot exceed NHCE average x 1.25

For instance, suppose that the ADP for NHCEs is 2.89%. This means that, in order to pass the ADP nondiscrimination test, the ADP for HCEs cannot exceed 2.89% + 2 — in other words, 4.89%.

Similarly, suppose that the ADP for NHCEs is 8.40%. This means that the ADP for HCEs cannot exceed 8.40 x 1.25 — in other words, 10.5%.

Finally, suppose that the ADP for NHCEs is 1.91%. This means that the ADP for HCEs cannot exceed 1.91 x 2 — in other words, 3.82%.

The ACP test employs methods similar to those used in the ADP test, but it uses employee after-tax contributions or matching contributions instead of average salary deferral.

So — how do 401(k) and 403(b) plans differ in terms of nondiscrimination testing? Whereas 401(k)s must pass both the ADP and ACP tests, 403(b)s have to pass only the ACP test.

The lack of an ADP test can be advantageous to a nonprofit organization because there is no way for the small core of executives that are usually the highly compensated members of the organization to fail the test and lose out on the full annual tax shelter. Next week, we’ll present a case study that shows an example of an organization that avoided the hassle of ADP testing by opting for a 403(b) instead of a 401(k) plan.

Amir B. Eyal, JD, CFP®, AIF® is the CEO of Mylestone Plans – a national leader that educates the members of the non-profit community on how to achieve their financial goals. Mylestone provides a comprehensive range of institutional services to hundreds of non-profit organizations, as well as private financial and investment planning to their leadership and employees.