Should a charity's retirement plan be a 403(b) or a 401(k)?

[Peter Gulia]

Imagine a 501(c)(3) charitable organization asks for your advice about whether it should establish its retirement plan as a 403(b) plan or a 401(k) plan.

Here are some hypothetical facts about this charity:

It has about 43 employees, all in one place.

There is no highly-compensated employee, and the charity anticipates there never will be one.

The highest-paid employee has gross compensation below $100,000.  The charity intends to keep her compensation below this mark that calls for reporting details in Form 990.

The plan would allow voluntary salary-reduction contributions, and might provide some matching contributions.

The charity's governing body believes none of the employees desires any investment beyond mutual fund shares.

For this situation, would you suggest a 403(b) plan or a 401(k) plan?  Why?

Which factors - whether about the different Internal Revenue Code provisions, or about differences in investments and services available - should a smart decision-maker consider?

[MoJo]

My standard recommendation for a "start-up" is a 401(k) - for the very simple reason that you have considerably more choices in service providers (for now) than you do for 403(b) plans.  I would add to that a few caveats - just for consideration.  First, your choice of 401(k) plan providers for a "start-up" are much more limited - but depending on growth, that could change as more providers vie fo rthe business.  Second, while I don't mean to pan insurance companies (I work for one), but many of the start-up  403(b) options are going to be group annuity products, and while they are light years better than contracts of years ago, the mere fact that it is an insurance contract adds some complexity (and maybe back-end misery, depending on the terms of that contract).  To this day, I fight with co-workers who use "contract" and "plan" interchangeably - AND THEY ARE IN THE BUSINESS.  Third and finally, there are still differences between k's and b's - and some like the special catch-up provisions in a b plan (but if they never had them, would they miss them in the future when it actually might be useful?)

[Flyboyjohn]

Agree with MoJo that 401k is clearly best for start up but going one step further I've been advocating since 2009 that existing ERISA 403b plans should change to 401k for a long list of reasons.

IMHO the only reason to ever use 403b is if you can qualify as non-ERISA

 

[Peter Gulia]

MoJo and Flyboyjohn, thank you for the helpful ideas.

Flyboyjohn, does it change your analysis if there are a few highly-compensated employees and applying 401(k)'s average-deferral-percentage test would sharply limit the HCEs' contributions?

MoJo, does it affect your analysis if the charity is sure it will not grow?

All BenefitsLink mavens, how much does choice of service providers matter if the plan is small and lacks purchasing power?

 

[MoJo]

14 hours ago, Flyboyjohn said:

Agree with MoJo that 401k is clearly best for start up but going one step further I've been advocating since 2009 that existing ERISA 403b plans should change to 401k for a long list of reasons.

IMHO the only reason to ever use 403b is if you can qualify as non-ERISA

 

Just curious if you have been successful in getting existing b plan sponsors to switch to a k plan?  My experience is that they aren't interested (or don't understand).

[MoJo]

13 hours ago, Fiduciary Guidance Counsel said:

MoJo, does it affect your analysis if the charity is sure it will not grow?

 

Not really - although the choice of service providers may be somewhat limited (unbundled is certainly an option and the choice of TPA's (more critical in many ways) may be greater).

[Belgarath]

Depending upon the precise census/management/HC status and numbers, may also be possible to layer on a 457(b) for some or all of those folks who might otherwise blow the ADP test.

I agree with the prior comments that in general terms, providers and investment options for 401(k) plans are far more diverse. Also, in general, financial advisors and CPA's tend to understand the 401(k) world better.

[Kevin C]

A 401(k) offers more flexibility in plan design, too.  That's the main reason we suggest 401(k) instead of 403(b) for most non-profit prospects.  Our non-profit clients typically have a core group of employees that have been there long term, but also have a significant number of people who work only a few hours per week or work only certain times of the year. Most of them are on limited budgets, so they appreciate being able to apply eligibility requirements and limit turnover of participants.  We also have a few non-profits with an HCE or two that sponsor safe harbor 401(k) plans. 

[Peter Gulia]

Thank you, all, for the further information.

 

[austin3515]

My opinion is why would you ever give up the ADP testing exemption.  For what?  There are providers out there who are quite good (American Funds RK Direct being one). "There are no HCE's today" is by no means indicative of what the lay of the land will be even in 5 years.  OK, I guess if limiting participation to those with a year of service is a critical organization goal (for example if there is extreme turnover) then I guess 401k.  But I have sat through to many non-profit takeovers where I had to address TESTING issues! That is just uncalled for with a non-profit.

[Flyboyjohn]

Two reasons the ADP test exemption is not important and worth giving up:

1. Charities usually have very few if any HCEs and if they do they can add a 457(b) to more than make up the reduced deferrals

2. Charities usually don't want a vesting schedule and have an employer contribution that easily meets safe harbor

If a charity has an ERISA 403(b) but their contribution is less than safe harbor I tell them to increase salaries by the former employer contributions, encourage employees to increase their deferrals by similar amounts and switch to a non-ERISA 403(b)

 

[austin3515]

How is a 457b an adequate replacement for a key executive?  OK, the other option is to have the 403b covering just the HCE's but now you've got a 403b with one person (good luck finding that provider) not to mention the expense and aggravation of 2 plans.  No HCE's today <> No HCE's ever. 

To put it more simply, with a 403b there is very little that can go wrong where you wish you had a 401k, but if you're a 401k there is a very obvious issue where you'll wish you had a 403b.  So I've never had a 403b client who wished they had a 401k, but I have had multiple 401k clients who wished they had a 403b.  And while there are fewer vendors, there ARE adequate vendors.

And once it's an issue it's very very difficult to unravel and change course.  It is more or less a permanent decision, particularly if there are any employer contributions with a vesting schedule (i.e., because termination = 100% vesting).

[jpod]

Also, in my experience the 457(b) is viewed by Non-Profit Executives as a vehicle to pour in the full extra $18,000 per year (as adjusted), whether it is elective money or fully vested employer money, in addition to the $18,000/$24,000 available under the 403(b).  It would be quite a horse of a different color to tell the Executive that while he may not be able to max out under the 401k plan do to ADP testing issues, he can "make it up" under the 457(b).  No, he's not "making up" anything if the mindset is as I described. 

[austin3515]

That and there's the whole "no rollover option" (except to another 457b of another charity, I'm sure that happens all the time..) and subject to claims of creditors thing.

[Kevin C]

Your non-profit clients are different than ours. The ones we have that are large enough to have HCEs typically provide enough employer contributions to the employees that safe harbor 401(k) isn't a problem.  Several of them also had the choice between an audit size 403(b) and a small plan 401(k).  We give them their options and let them decide.  

 

Now, if it's a Church plan, it's definitely a 403(b).

[austin3515]

Ah yes, if you're a safe harbor then it is a moot point! Unless of course, enrollment in the school declines, or federal funding is cut, or state funding is cut, or a recession hits and people are less generous with their charitable contributions, and if the budget otherwise needs to be balanced (and of course retirement is an easy target)...

And yes of course I agree with the audit/no audit issue for those in a gray area.  But hopefully Trump's administration will implement the "audit based on people with money proposal" which would drastically take that consideration out of the question (since people with less than a year tend not to contribute as often).

[Belgarath]

One other observation, which may or may not be important depending upon the client's wishes for plan design.

If they want to allow in-service distributions of employer contributions, especially for hardship (and many do) then the 403(b) is useless when using custodial accounts. You can't take in-service distributions from employer contributions to 403(b) custodial accounts unless disabled or age 59-1/2, whereas under the 401(k) you CAN allow in-service distributions on the employer contributions.

P.S.- I'm ignoring the possibility of 12/31/88 funds for purposes of my general observation above.

[austin3515]

Belgarath, that is an obnoxious rule.  One of the most obnoxious I've seen.  What is the point!!

[Belgarath]

It is indeed obnoxious, ridiculous. asinine, and any of a number of other pejorative terms that you might care to employ.

What is the point? Or to quote Basil Fawlty, "What is the bloody point?" I couldn't begin to imagine. I just know that's what the regs require. At a guess, and only a guess, this restriction only applies to custodial accounts because in the dim and distant past, 403(b) were annuities only, and so when this provision was instituted, annuity contracts were "grandfathered."