403(b) Good Part II: B or K?

August 5, 2008 (PLANSPONSOR (b)lines) - In the wake of the 403(b) regulations under the Internal Revenue Code, tax-exempt entities are asking whether they should forget the 403(b) arrangement and adopt a 401(k) plan instead. (Public schools don't have the option; government entities haven't been able to sponsor a 401(k) plan since the Tax Reform Act of 1986.) Some considerations are highlighted below.

First, let’s consider the tax-exempt which makes no employer contributions and has limited employer involvement (as defined in U.S. Department of Labor regulation 2510.3-2(f)).   This isn’t an ERISA plan.   So what should sponsors consider?  

  • 401(k) plans don’t enjoy a similar exemption from ERISA.   Switching would mean more work at the plan level, such as the annual Form 5500 reporting form, the summary plan description and summary annual reports that have to be given to employees, discrimination testing, etc.
  • Even though the 403(b) tax regs require a written plan, the B documentation will generally be simpler than the complex plan document required for a 401(k) plan.  
  • The 401(k) plan will be subject to the ERISA fiduciary rules, which a non-ERISA B plan is not – though there may be similar state law rules that apply to the non-ERISA plan.   In other words, there may not be a material difference between the two types of plans for this purpose.
  • Also, the plan document, reporting and disclosure requirements are often handled to a large degree by a provider.   Thus, adoption of a 401(k) plan vs. a non-ERISA 403(b) may not create a significant additional oversight burden on the employer, especially if state laws already mandate employer oversight for non-ERISA 403(b)s.      

What about 403(b) plans subject to ERISA?  

  • The plan document requirement is similar for both types of plan.   ERISA requires a written plan document, though as noted, the 403(b) document will likely be simpler than the 401(k) plan.   (Note that the ERISA document will also need to conform to the 403(b) tax regs.)
  • ERISA 403(b)s are already subject to annual reporting, though until now the Form 5500 requirement has been minimal.   Starting in 2009, 403(b)s will have to complete all items in the Form 5500 and, if they have more than 100 participants, have an annual audit.   This is the same as the 401(k).
  • Employer contributions to both types of plan are subject to discrimination testing, so again, there is no real difference.
  • 403(b)s are subject to the universal availability requirement, meaning virtually all employees have to be offered the chance to participate.   The coverage rules for 401(k)s aren’t so different, though union employees must be offered the plan under the universal availability rule, whereas union coverage and benefits can be a matter of negotiation in the 401(k) plan context.  

The big difference, however, is that employee deferrals to a 401(k) plan are subject to an annual discrimination test that doesn’t apply to 403(b) plans.   This means added expense to do the testing and possibly returning deferrals to the highly paid employees in the 401(k) plan, a feature that the higher paid group generally doesn’t appreciate.   However, if the employer already makes meaningful contributions, it could use a safe harbor design in a 401(k) plan, which eliminates the need for testing altogether.

On balance, as a practical matter, there's not that much difference between the 401(k) plan and either an ERISA or non-ERISA 403(b) plan - except in the area of products and services.   The 401(k) marketplace has honed product offerings for a couple of decades.   Up to now, innovations in investments and services have tended to come faster here than in the 403(b) world.   Further, costs overall tend to be lower for 401(k) plans.   On the other hand, 403(b) brokers have generally had a much greater "hands on" relationship with the participants in the plan than with 401(k) plans.   This partially explains the difference in costs borne by the participants.   This all may change going forward, with the increased interest in 403(b) plans brought about by the tax regulations.   But until now, the tradeoff could be explained as more investments and services at lower cost in the 401(k) versus greater individual employee service in the 403(b).  

The issue of B vs. K is more complex than we've been able to discuss here - this is just a short sample.   The 403(b) regulations are clearly making Bs much more like Ks, but there are still differences and pros and cons of each.   Tax-exempts considering the change should get expert advice before taking the plunge.   

- Bruce Ashton, Reish Luftman Reicher & Cohen

NOTE: This feature is to provide general information only, does not constitute legal advice as part of an attorney-client relationship, and cannot be used or substituted for legal or tax advice.

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