(b)lines Ask the Experts – Why a 403(b), not a 401(k)?

November 8, 2011 (PLANSPONSOR (b)lines) – “As a new employee at a nonprofit, I have to ask—why do nonprofits have 403(b) plans in the first place? Could they have not started a 401(k) instead?”

Michael A. Webb, Vice President, Retirement Services, Cammack LaRhette Consulting, answers:  

To answer this question, the Experts believe you need to look at the history of such plans. The reality for many nonprofit organizations is that, when they started their 403(b) plans, 401(k)s simply did not exist. Section 403(b) was added to the Internal Revenue Code in 1958, while Section 401(k) was not added to the code until 20 years later, in 1978. In addition, for many years after the introduction of Section 401(k) to the Code, nonprofits were prohibited by law from establishing a 401(k) plan. So, as you can see, for many nonprofits, 403(b) plans were simply the “only game in town” at the time that such organizations wished to establish an opportunity for their employees to make pre-tax elective deferrals to a retirement plan.    

However, beginning in 1997, nonprofits could choose between a 401(k) and a 403(b) plan. However, there was still one major problem; guidance as to how to terminate a 403(b) plan at the time was extremely unclear.  And, the IRS would not permit the assets of the 403(b) plan to be transferred or merged into the 401(k) plan. Thus, if a nonprofit wished to switch to a 401(k) plan, they would essentially need to maintain TWO plans in the absence of guidance as to how to proper unwind the 403(b) plan, which was too much of an administrative burden for many nonprofits to bear. Recent guidance has provided some clarity as to how to terminate a 403(b) plan, but some unanswered questions remain.     

In addition, there remain several advantages for a nonprofit to choose a 403(b) plan over a 401(k) plan, chief of which is the lack of nondiscrimination testing of elective deferrals to a 403(b) plan, known as ADP testing in the 401(k) world.  Another reason is that many tax-exempt 403(b) sponsors were church-related and those also have a number of special 403(b) rules unavailable to 401(k) plans.  It is for these reasons that 403(b) plans remain the dominant defined contribution plan type among nonprofit organizations.  


NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.