Sec. 403(b) retirement plans: A comparison with 401(k) plans.

• Author: Blankenship, Vorris J.

Tax-exempt charities may adopt two types of funded tax-favored retirement plans. They may adopt Sec. 403(b) plans and they may adopt qualified plans (including Sec. 401 (k) plans). Public schools may also adopt both 403(b) plans and qualified plans (not including 401(k) plans). (1) Many tax-exempt entities and public schools have chosen 403(b) plans, for what they perceive to be favorable features. This article highlights differences between 403(b) and 401(k) plans.

As background, Sec. 403(b) plans may be established by (1) tax-exempt educational, charitable, scientific, literary, sports, religious, or public safety testing organizations (hereafter "501(c)(3) organizations"); (2) public school systems (including Indian schools); (3) employers of religious ministers or self-employed ministers (an umbrella term covering other clergy members, too); and (4) certain health and hospital service organizations. (3)

Sec. 403(b) plans are of three general types. The first type consists of commercially purchased annuities. (4) The second type is a custodial account that may invest only in regulated mutual funds (referred to hereafter in this article as a "custodial account"). (5) The third type is a "retirement income account," a type of individual account plan only churches (a term that covers a wide variety of religious organizations) and their related organizations may establish. Retirement income accounts need not limit their investments to purchased annuities or mutual funds and may be established for self-employed ministers. (6)

The statutory tax law requirements for qualification as a 403(b) plan are generally not as strict at those applicable to qualified plans. Unfortunately, though, many of the stricter requirements are instead imposed on 403(b) plans by the labor law provisions of the Employee Retirement Income Security Act of 1974 (ERISA). ERISA grants protections to retirement plan participants, their spouses, and beneficiaries. Although a 403(b) plan that omits ERISA mandates is not disqualified for tax purposes, the omission will invite the imposition of civil and criminal penalties on the employer for labor law violations. (7) For that reason, employers normally provide for the more strict ERISA requirements in 403(b) plans.

Nevertheless, the ERISA requirements are not imposed on certain 403(b) plans referred to in this article as "unrestricted 403(b) plans." Unrestricted 403(b) plans include church plans, public school plans, and employee-sponsored 403(b) plans. (8) An employee-sponsored plan is a plan established by employees with minimal participation by the employer. In an employee-sponsored plan, the following requirements must be met:

1. Employee participation in the plan is voluntary.

2. The only involvement of the employer is to: a. Allow sellers of annuity contracts or custodial accounts to present their products to employees; b. Request information regarding the products and their sellers; c. Summarize information for employees; d. Collect, record, and submit amounts under salary reduction agreements', e. Hold employee group annuity contracts in the employer's name; and f. Limit products and sellers to those providing employees with a reasonable choice.

3. All rights in the annuity contract or custodial account are enforceable only by employees, beneficiaries, and their representatives.

4. The employer is entitled to compensation or reimbursement only for reasonable expenses incurred in administering a salary reduction agreement. (9)

   Sec. 403(b) plans provide for salary reduction agreements under which an employee may elect to have a portion of his or her compensation contributed tax-free to the plan by the employer. (10 ) Sec. 401(k) plans similarly provide for cash or deferred arrangements allowing a participant to elect tax-free employer contributions to the plan. (11) Since practitioners are generally much more familiar with 401(k) plans than with 403(b) plans, this article discusses how 403(b) plans differ from 401(k) plans. Note that this article does not purport to explain the differences between 403(b) plans and 401(k) plans to the extent those differences relate to formation and administration. Nor does it attempt to compare the rules governing the required coverage of employees (nondiscrimination) or the qualification of employees for coverage. Instead this article takes an actual participant's perspective by focusing on a comparison of the nature and amounts of contributions to, and distributions from, 403(b) and 401 (k) plans, for an admittedly qualified participant.

   In many ways, the provisions governing distributions from 403(b) and 401 (k) plans are substantially the same. For example, the provisions are almost identical with respect to the treatment of plan loans, rollovers to and from the plans, applicability of the penalty on early distributions, required minimum distributions, and the availability of Roth conversions. Nevertheless, the differences can be significant. Those differences are discussed in the remainder of this article.

   Types of contributions

   One point of comparison between these two types of retirement plans concerns the contributions made to the plan. As noted above, both 403(b) plans and 401(k) plans provide that an employee may elect to have his or her employer contribute a portion of the employee's compensation to the plan in lieu of cash compensation. Such contributions are generally excluded from gross income and are referred to in this article as qualifying elective contributions (QECs). Roth contributions may also be QECs, except that they are taxable. (12)

   An employer may also contribute to a 401 (k) plan amounts designated as qualified nonelective contributions (QNECs) and qualified matching contributions (QMACs). QMACs are employer contributions that match an employee's elective contributions (QECs); these matching contributions must satisfy the same nonforfeitability and distribution commencement constraints that apply to QECs (as described below). QNECs are employer contributions other than QECs or QMACs that also satisfy the nonforfeitability and distribution commencement constraints applicable to QECs. (13)

   Unlike 401(k) plans, 403(b) plans do not expressly provide for QNECs or QMACs (although the IRS has indicated that 403(b) plans may voluntarily provide for them). (14) This difference becomes important when comparing contributions to, and distributions from, the two types of plans.

   Annual limits on contributions

   There is a difference between 403(b) and 401(k) plans related to annual contribution limits. Generally, QECs for a tax year are limited by statute to the lesser of an employee's compensation or an inflation-adjusted dollar amount ($19,500 for 2020 and 2021). (15) This basic limit applies to the aggregate of all QECs made on behalf of an employee to 401(k) and 403(b) plans. (16)

   If an employee over age 50 has already made the maximum allowed QECs (equal to the basic limit) to 401(k) and 403(b) plans, the plans may nevertheless allow the employee to make additional QECs that are catch-up contributions. (17) Catch-up contributions to the plans for a tax year are limited in the aggregate to the lesser of (1) an inflation-adjusted dollar amount ($6,500 for 2020 and 2021), or (2) the amount of the employee's compensation reduced by QECs already made under the basic limit. (18)

   In addition, if an employee has completed 15 years of service, 403(b) plans of certain educational, medical, welfare, and church organizations may allow an employee to make additional QECs that are special catch-up contributions. This special catch-up provision is specifically designed to compensate for allowable QECs not taken in prior years. It is limited to $3,000 in any one tax year and is limited to $15,000 for all tax years. (19) An employee eligible to make both the special catch-up contribution and the over-50 catch-up contribution may elect both without offsetting one against the other. (20)

   In addition, for each employee, the aggregate of contributions and forfeitures to 401(k), 403(b), and other defined contribution plans (not including 457 government plans) generally may not exceed an overall inflation-adjusted dollar amount ($57,000 for 2020 and $58,000 for 2021). (21) Rollover funds and over-50 catch-up contributions are, however, not subject to this limitation. (22)

   Finally, 401(k) and 403(b) plans are subject to various complicated nondiscrimination provisions that might have the effect of further limiting contributions by or for highly compensated employees. (23) Of note is one such provision that limits the amount of an employee's compensation that may be taken into account in computing contributions to the plan (compensation of $285,000 for 2020 and 1290,000 for 2021). (24)

   An employee participating in both a 403(b) plan and a 401 (k) plan

   In some cases, an employer may have more than one type of retirement plan. An employer with a 403(b) plan may also adopt a 401 (k) plan, but generally only if the employer is a tax-exempt entity that is not a public school system and is not a 501(c)(3) organization with substantial governmental attributes. (25 ) Nevertheless, a public school system or governmental-type 501(c)(3) organization may also maintain a 401 (k) plan if the plan was adopted before May 7, 1986. (26) Depending on the circumstances, there may be advantages to maintaining both a 401 (k) plan and a 403(b) plan. As explained above, though, because of the single QEC basic limit and single over-50 catch-up limit applicable to 401(k) and 403(b) plans, maintaining a 401(k) plan in addition to a 403(b) plan will not increase the QECs or catch-up contributions that an employee may make.

   An employee participating in both a 403(b) plan and a 457 government plan

   It is worth mentioning Sec. 457 government plans here, too. An employee of a public school system or a 501(c)(3) organization with substantial governmental attributes may derive...