When offering retirement plan benefits, selecting the right type is crucial for both employers and their employees. 401(k) and 403(b) plans are two popular retirement savings vehicles. Understanding the distinctions between the two can help nonprofit organizations align their plans with organizational goals and provide the best options for plan participants.

401(k)s and 403(b)s are both retirement savings plans, but they serve different types of workers. Private-sector employers can only set up 401(k)s, while public school, nonprofit and some government employers can pick either a 401(k) or a 403(b). Both plans have tax benefits and are important for a complete benefits package, but they have different rules and obligations.

By gaining a deeper understanding of both retirement savings options, you will make more informed decisions, ensuring the plan you offer is designed to meet your organization’s and employees’ needs

Plan Eligibility Period

The first difference between 401(k)s and 403(b)s is plan eligibility. 401(k)s may include an eligibility period, which means employees must meet specific entry criteria, such as length of service or hours worked, before employees can participate in the plan.

A 403(b) plan, however, operates under the principle of the universal availability rule. This means the plan must be offered to all employees with a few exceptions. For example, employees who work fewer than 20 hours per week, students and certain part-time staff can be excluded. Keep in mind that if any of these employees work 1,000 hours or more in a year, they must be allowed to participate in the 403(b) plan.

Key takeaway: If you want to implement a year of service or another eligibility requirement before employees can participate in the plan, a 401(k) may be the right choice. Review the options with your third-party administrator (TPA) and financial advisor.

ADP Exemption for 403(b) Plans

A 403(b) plan is exempt from the ADP (Actual Deferral Percentage) test, which compares the average deferral percentage of Highly Compensated Employees (HCEs) to the average deferral percentage of Non-Highly Compensated Employees (NHCEs). The IRS defines which employees are considered HCEs each year based on income. Eliminating this test can benefit organizations with a sizable population that meets or exceeds that compensation limit.

403(b) plans are subject, however, to the ACP (Actual Contribution Percentage) test, which looks at matching contributions in the same manner as deferrals under the ADP test.

Key takeaway: We recommend engaging a TPA and financial advisor when setting up your retirement plan. You’ll partner with them to evaluate your organization’s objectives, identify any HCEs and determine whether the plan is intended to benefit them specifically or the staff in general.

Catch-up Contributions

Both 401(k) and 403(b) plans offer catch-up contributions, allowing participants aged 50 or older to contribute additional funds beyond the standard annual limits. This provision helps older employees boost their retirement savings as they approach retirement age. For 2024, the catch-up contribution limit for both plans is $7,500.

The 403(b) plan may have a unique catch-up contribution provision for long-term employees, which isn’t available in a 401(k). Employees with at least 15 years of service at the same employer may be eligible for an extra catch-up contribution, allowing them to contribute even more to their retirement savings account. (Not all 403(b)s offer this feature.)

Key takeaway: Employers must understand the nuances of the retirement plan they offer to meet their fiduciary responsibilities. If a significant percentage of employees are over the age of 50, catch-up contributions could be an important consideration. Regularly reviewing the plan with trusted retirement plan partners can ensure understanding and compliance.

Matching Contributions

Employer-matching contributions are a key feature in many retirement plans. In 401(k) plans, company matching is prevalent and often a significant part of the retirement benefits package. Employers typically match a percentage of the employee’s contributions up to a specific limit, enhancing the employee’s total retirement savings.

Employer matching in 403(b) plans can sometimes be quite generous, as benefits are valued as part of a nonprofit’s overall compensation package.

Key takeaway: Deciding whether to offer a company match (and how much it should be) is a significant decision for employers. Offering a matching contribution can provide greater savings opportunities for employees, enhancing their retirement readiness and increasing their satisfaction. It’s ideal to discuss these options with your TPA and financial advisor to ensure the best outcome for both the organization and its employees.

Inherent Problems in an Old 403(b)

Before 2009, 403(b) plans were subject to significantly less regulatory scrutiny than 401(k) plans. For instance, they weren’t required to file a comprehensive Form 5500 or maintain a formal written plan document. However, in 2009, the IRS mandated new requirements to bring 403(b) plans more in line with the 401(k) regulatory framework.

As a result, some 403(b) plans have struggled to comply with these newer regulations. Plan sponsors may be unaware of the 2009 regulatory changes and may not realize their plan is noncompliant, putting it at risk.

Key takeaway: To meet the needs of their retirement plan sponsor clients, TPAs and financial advisors must remain current on plan administration, including regulatory obligations. Your retirement partners can review your 403(b) plan’s structure and, if needed, help you bring it back into compliance. This ensures you meet the IRS and Department of Labor rules for operating your plan legally.

We’re Here to Help

Our Definiti team partners with retirement plan sponsors and financial advisors nationwide, including private-sector companies and nonprofit agencies.

We’ve helped many 403(b) retirement plan sponsors:

• Assess their plan’s overall health and recommend how it could be improved to meet their goals.
• Update their plan to address regulatory issues and implement best practices for sound administration.
• Switch to a new type of retirement plan, like a 401(k) or safe harbor plan, to meet strategic objectives.

If you currently don’t offer your employees a retirement benefit, we can partner with you and your financial advisor on the plan set-up, designing it in a way that benefits your business and your people. If you need help administering your plan, we can take on many day-to-day tasks, like processing payroll contributions and enrolling participants.

We welcome our current clients to contact their Definiti Retirement Plan Consultant (RPC) with any questions about retirement plans. If Definiti isn’t one of your trusted retirement services providers, let’s start the conversation. Call 1-888-912-3653 or email salessupport@definiti.com.