Know Your DC Plans

For sponsors in the for-profit world, there is not much choice for defined contribution plans: 401(k) plans are available, but 403(b) and 457(b) plans are not.

For sponsors in the tax-exempt, church and governmental fields, however, all three are available, and there are many trade-offs and nuances to consider in choosing between them.

457(b)s for Tax-Exempt Organizations: A ‘Top Hat’

457(b) plans are used very differently by the two types of employers that use them: governmental sponsors and tax-exempt, or nonprofit, sponsors.

A 457(b) used by a tax-exempt employer is “a top-hat plan,” says David Ashner, an attorney with Groom Law Group. The plan will be used for a select group of employees on top of another DC plan, usually a 403(b).

Robert Abramowitz, a partner in Morgan, Lewis & Bockius LLP, explains that having a top hat 457 allows select employees, usually executives and other highly paid employees, to contribute more to their retirement. The contribution limits for 2024 for both a 403(b) and a 457(b) are $23,000, and employees with access to both can max out each for a total of $46,000.

There are not any clear regulations for which employees would qualify for a top hat plan, Abramowitz says, and “there has been a lot of litigation in that space.” Some sponsors limit it to a few executives or to “the top couple of percent” of employees. It is not subject to the highly-compensated-employee threshold, set at $155,000 for 2024. Tax-exempt 457(b) plan sponsors do not have the option to offer a Roth account, though government 457(b) sponsors can.

Abramowitz says that 457(b) top hat plans are more vulnerable to disqualification than other plans. He says he tells his clients to “be very careful in its administration, because technically the IRS could come and disqualify the entire plan for operational errors.” This is because top hat plans are often seen as a form of executive compensation, rather than being used for retirement security.

457(b)s for Government Sponsors

For governmental plans and plans sponsored by a qualified church-controlled organization, such as a hospital, 457(b) plans are used as the primary DC plan option, rather than as an add-on to a 403(b), which is different than the broader tax-exempt sector, says Abramowitz. “cannot sponsor a 457(b) and must use a 403(b).

Governmental 457(b)s are not subject to ERISA, Abramowitz says, and can be used by the general employee base of the sponsor. They also lack an early withdrawal penalty, and

Church organizations can use 457(b)s, but it “may not be a good idea, because in all likelihood, a 403(b) plan would be more attractive for more employees,” Abramowitz says. This is because 457(b)s sponsored by state or local governments during bankruptcy, whereas those sponsored by a tax-exempt organization are not.

According to the IRS, “plan assets are not held in trust for employees but remain the property of the employer (available to its general creditors in the event of litigation or bankruptcy).”

A 403(b) “is just safer for rank-and-file employees,” Abramowitz says, since in a 457(b) plan, they are not protected from their employer’s creditors if the sponsor is not a governmental organization.

403(b) Plans

Ashner explains that 403(b) plans, another DC plan type available to nonprofits and governmental institutions, are similar to 401(k)s. The primary trade-off is that 403(b)s have fewer testing and compliance requirements, while 401(k)s “typically have a wider range of investment options.”

For example, 403(b)s do not need to have nondiscrimination testing for employee contributions and instead are subject to a universal eligibility requirement. However, they are limited to annuities and mutual funds and cannot offer collective investment trusts as investments.

Abramowitz says 403(b)s are very common in higher education, and so many sponsors in that field sponsor one, because “that’s what other colleges or universities around the country are doing.”

401(k) plans

Both Ashner and Abramowitz agree that the main reason for a nonprofit or government employer to offer a 401(k) is the “wider array of investment options,” such as CITs and the option of self-directed accounts.

Abramowitz adds that some states, such as New Jersey, tax deferrals to 403(b)s and not to 401(k)s, meaning 401(k)s have a significant advantage for the purposes of state income taxes. But counting against those considerations, there are “more burdensome testing rules” to factor in, because 401(k)s have more nondiscrimination testing.

Abramowitz says there are many factors to consider, and “it’s not one-size-fits-all. You have to analyze employer objectives and the employees covered.”