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

Case Study: Avoiding Nondiscrimination Testing Failure with a 403(b) Plan

Organization XYZ has a 403(b) plan that offers a 3% match for employer contributions. The organization consists of six employees, two of which are highly compensated (i.e., earn $120,000 or more per year), and four of which are not highly compensated (i.e., earn less than $120,000 per year). The following table shows their compensation, contribution to their retirement accounts, and the corresponding ACP and ADP data. As we’ll see, Organization XYZ was wise to choose a 403(b) plan over a 401(k) plan, as by doing so, they avoid failing the ADP test.

Recall the following rules regarding the maximum spread that a plan must comply with in order to pass ADP and ACP nondiscrimination tests:

In the above example, the average ACP for NHCEs is 2.25%. This means that the average ACP for HCEs must not exceed 2.25% + 2, or 4.25%. As we see in the table above, the average ACP for HCEs is 3%, so Organization XYZ passes the ACP test.

However, the ADP test is a different story. The average ADP for NHCEs is 6.25%, meaning that the average ADP for HCEs cannot exceed 8.25%. However, the average ADP for HCEs is 17.6%, meaning that Organization XYZ would fail the ADP test.

If Organization XYZ were using a 401(k) plan, they would fail the ADP test, and be forced to take corrective action; namely, HCEs would not be able to shelter the full allowable amount, and would thus have to pay income tax on the amount not allowed. Recall, however, that 403(b) plans require that companies pass only the ACP test, and not the ADP test. Therefore, Organization XYZ could avoid the hassle of failing the ADP test had they opted for a 403(b) rather than 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.