Navigating the Higher Education Retirement Plan Number Jumble: 403(b), 401(k) and/or 457(b)
The number of questions from clients and friends of the firm that we have received lately has made me aware that misunderstanding remains rampant of the key distinctions among the three major types of defined contribution plans utilized by higher education institutions: 403(b), 401(k), and 457(b). This article should help clarify which plan types, or what combination of plan types to use, depending on the specific fact pattern.
The most important distinctions among the three types of plans are the following, in order of importance:
1. Employer eligibility
It is obviously easier to decide among plan types if a particular type of employer is ineligible to sponsor a certain type of plan. For example, public colleges and universities may not maintain a 401(k) plan unless their particular state maintained one that was in place more than twenty-five years ago (5/6/1986). Likewise, private tax-exempts that are college and university affiliates that are not 501(c)(3) educational/charitable organizations, such as associations and clubs, may not maintain a 403(b) plan. And, though public and private colleges and universities may maintain a 457(b) plan, the rules governing such plans vary widely for these two types of employers.
2. Nondiscrimination testing
Our prior article discussed the major reason why many private tax-exempt entities - including religious universities who would qualify as church organizations under section 414(e) of the Code - continue to use 403(b), as opposed to 401(k) plans. (Another change from a few years ago is that such higher education organizations are permitted to utilize both plan types.) Their rationale is that it is not necessary to test 403(b) salary deferral employee contributions. As a result, highly compensated employees (defined in 2011 as those who earned in excess of $110,000 in 2010) have no additional limitations imposed on their ability to save, other than the overall IRS 402(g) restrictions. Plan sponsors of 401(k) plans must collect data each year and test the 401(k) plan to determine the average contribution made by all non-highly compensated employees. This average includes contributions for noncontributing lower paid per diems, part-timers, and adjuncts with more than one year of service.
457(b) plans present the opposite problem for private tax-exempt entities. A 457(b) plan sponsored by a private college/university that is not a 414(e) religious organization is of limited use, since such "top hat" plans are required to discriminate in favor of highly compensated employees. Thus, they cannot serve as a primary retirement plan for such organizations, but only as a supplemental plan for select groups of management employees.
The ability not to test salary deferral contributions in a 403(b) plan is generally considered a deciding factor for choosing a 403(b) plan over a 401(k) for any private higher education institution, including 414(e) religious organizations such as faith-based colleges/universities. Typically, at colleges and universities, unmatched elective (as opposed to mandatory) deferrals for non-highly compensated employees average about 2%. (Those who would defer zero would be counted in the average.) At this level, HCE's in a 401(k) plan would be limited to 4%-5% of pay, rather than regular IRS limit of 100% of pay up to $16,500 per year, or $22,000 if age 50 or older. So individuals such as a college/university president would have their deferral restricted in a 401(k) plan, but not in a 403(b) plan. Additionally, higher education institutions will be eligible to offer the 15+ years of service increased limit in a 403(b) plan, but not in a 401(k) plan. The 15-year catch-up election permits employees of certain organizations who have completed 15 or more years of employment to defer up to an additional $3,000, subject to certain restrictions; this feature is unique to 403(b) plans.
It is, however, important to understand that, for certain types of organizations, nondiscrimination testing is not a factor at all in plan choice. Governmental plans, such as those sponsored by public universities, for example, are never subject to nondiscrimination testing, and 457(b) plans can be offered to all employees of such organizations.
A further advantage of 457(b) plans should be noted: employer contributions of any type may be discriminatory in nature, whereas in 401(k) and 403(b) plans, employer contributions must be tested for nondiscrimination (except for the organizations which are exempt from testing as described above).
3. ERISA coverage
Another defining feature of 403(b) and 457(b) plans is that elective-deferral only plans of private higher education institutions can generally be exempt from ERISA. Though this election is not common among college and university 403(b) plans, it is not even possible for 401(k) plans of such organizations. (Public and faith-based colleges and universities are not subject to ERISA regardless of plan type).
457(b) plans of private education employers are technically subject to ERISA, but a single "top hat" filing with the government essentially exempts the plan from ERISA requirements. For 403(b) plans to be exempt, the plan sponsor must permit elective deferrals only (no employer contributions) and satisfy several other requirements which generally restrict employer involvement in the plan.
For such plans, no summary plan descriptions are required, no annual 5500's or summary annual reports need be filed and distributed, and an annual accountant's opinion is not necessary. The annual audit alone can be a significant cost factor, as well as an administrative burden. The 403(b) exemption is not as attractive as it once was, due to new regulatory requirements, but an ERISA exemption remains an important option for 403(b) and 457(b) plans and one that does not exist in the world of 401(k).
4. Universal availability
The universal availability requirement is unique to the 403(b) plan, which means that all employees, with limited exceptions, must be permitted to make elective deferrals from date of hire. In 401(k) plans, eligibility to make elective deferrals can be restricted, subject to nondiscrimination testing requirements. Public higher education institution 457(b) plans have no such requirements in this regard; plan sponsors can allow all or any employees of their choosing, to participate in such plans. As mentioned above, private college/university 457(b) plans can only permit select management and highly compensated employees to participate. It should also be noted that independent contractors may be permitted to participate in 457(b) plans as well, but not in 401(k)/403(b) plans.
5. Contribution limits
Though elective deferral limits to all three plan types are $16,500 in 2011, there are some other important contribution limit distinctions. The limit on combined elective deferral and employer contributions to a 457(b) plan is the same as the elective deferral limit ($16,500), while in both 401(k) and 403(b) plans the combined limit is significantly larger, comprising up to $49,000 in 2011, depending on compensation.
However, the 457(b) elective deferral limit is not offset by 401(k) or 403(b) deferrals, meaning that $16,500 may be deferred into a 457(b) plan regardless of whether any deferrals or employer contributions have been made to a 403(b)/401(k). That opportunity essentially constitutes a double deferral for both plans. The age 50 catch-up election, which expands the $16,500 limit in 2011 to $22,000, is available in 403(b), 401(k) and public college/university 457(b) plans, but not for 457(b) plans of private higher education institutions.
There are two additional special elections for elective deferrals, one unique to 403(b) plans, and one unique to 457(b) plans. A holdover from the days of the maximum exclusion allowance for 403(b) plans is the 15-year catch-up election, whereby a plan can permit employees with 15 years or more of service, and who satisfy additional requirements, to defer up to an extra $3,000 over and above the 402(g) limit of $16,500 ($22,000 if age 50 or older) in 2011. As pointed out in a prior article, this election is extremely complicated to calculate. The 457(b) election is limited to those in their final three years of employment prior to retirement, but can permit an additional elective deferral amount of up to $16,500 in 2011.
403(b) and 401(k) plans generally mirror each other in terms of distribution restrictions. For example, elective deferrals may not be withdrawn in either plan type until a) the attainment of age 59 ½, termination of employment, hardship, or death/disability. However, 457(b) plans have different restrictions, as contributions may not be withdrawn until severance of employment, attainment of age 70 ½, and unforeseeable emergency (different rules from hardship). In addition, there are further restrictions as to the type of distributions that may be taken from the 457(b) plan of a private college/university, and rollovers are not permitted from such plans. One advantage of 457(b) plans, however, is that the 10% excise tax for distributions prior to age 59 ½ does not apply.
In 401(k) plans, the most common type of movement of plan assets from one provider to another is an employer-directed transfer of all assets. Since 401(k) plans rarely utilize more than one provider, the only reason to move assets would be if a new provider is selected to replace the existing plan provider. The situation is similar for 457(b) plans, though some participants use socalled "plan-to-plan" transfer provisions in cases where a rollover would not be permitted (i.e., for private higher education institution plans).
For 403(b) plans the regime is much more flexible, though restricted somewhat from its historic flexibility by the final 403(b) regulations that became effective a few years ago. Employers may transfer plan assets from one provider to another, though such transfers are more likely to be restricted at the provider contract level than is the case with a 401(k) plan. In addition, plan participants may transfer plan assets, in the form of an exchange, to any approved provider in a 403(b) plan. Finally, plan-to-plan transfers are also permitted, though in such situations employees often opt for a rollover as opposed to a transfer.
8. Payroll taxes
401(k) and 403(b) employer contributions are not subject to payroll taxes such as FICA or Medicare. Since 457(b) plans are deferred compensation plans rather than retirement plans, employer contributions are treated as compensation that is indeed subject to payroll taxes.
9. Provider availability
A myriad of providers service 401(k) plans. 403(b) and 457(b) plan assets, however, are concentrated among a fairly small selection of providers. Although this relative lack of competition can affect pricing and marketplace advancements for large plans, 401(k)/ 403(b) and 457(b) product/service offerings will often be comparable. In addition, while it is not uncommon to see multiple providers offered in a 403(b) plan, it is less common in 457(b) plans and extremely rare in 401(k) plans.
Another important distinction in 403(b) plans is that they are limited with respect to the types of investments that can be offered. Many types of investments that are permitted in 401(k) and 457(b) plans, such as individual securities, are prohibited in 403(b) plans, which are limited to 403(b)(1) fixed/ variable annuities and 403(b)(7) custodial accounts (mutual funds). It should also be noted that 457(b) plans can be subject to state law restrictions as to investment type. 11. Post-employment contributions 401(k) and 457(b) plans do not permit post-employment employer contributions, but 403(b) plans allow post employment employer contributions (not elective deferrals) to be made for up to five tax years following termination of employment.
Other differences exist among plan types, but these are the primary distinctions a decision maker needs to understand for selecting from among the plan types.
403(b) plans remain a more attractive option than 401(k) plans for many higher education plan sponsors. Indeed, for private colleges/universities, 457(b) plans serve as little more than a perk for select management and highly compensated employees. On the other hand, a 457(b) plan represents a viable alternative for public higher education institutions and for those public colleges/universities with access to grandfathered 401(k) plans a 401(k) can be a competitive option as well.
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.
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