Episode 5: What is a 403(b) Plan?
00:06
Hello and welcome to Revamping Retirement, a podcast brought to you by Cammack Retirement Group, where we tackle the retirement plan related issues plaguing fiduciaries and plan sponsors. Our host, Mike Webb, has more than 25 years of experience in the retirement plan industry and is a nationally recognized subject matter expert. We hope you enjoy Revamping Retirement.
00:29
Thanks, Kara McCauley, our producer, and hello out there everyone in Podcast Land. So glad you could join us once again for episode 5. Has it been 5 already of Revamping Retirement? My name is Mike Webb and for the next 10 minutes or so we’re going to again, the goal here at Revamping Retirement is to try to have a little fun with retirement plan topics and this week’s topic is going to be a challenge to have fun because
00:57
It is 403B plans and stay with me please, please don’t turn off your podcast just yet. I promise that will make us exciting. But yes, some of you are like probably 401(k) folks and really have no interest in me talking about 403B. And conversely, some of you are 403B people probably don’t have any interest in me talking about 403B. But what I hope to do in the next few minutes is to kind of…
01:23
Demystify 403B for those of you who know about it and even for those of you who do know about 403B to try to give you few nuggets that you might not have heard elsewhere on the topic. But before we get started, 403B is the topic and as always, our trivia question is going to be based on that topic. So this month’s trivia question for revamping retirement is, what year?
01:52
was 403B added to the Internal Revenue Code? What year was Section 403(b) added to the Internal Revenue Code? The answer will come at the end of our podcast. Until then, I’m sure you’re already researching your many sources out there to try to find out when Section 403(b) was added to the Code, but these are a lot more fun if you try to answer them off the top of your head, so no cheating out there.
02:19
And we’ll get to the answer, like I said, in just a few minutes. So, 403B plans. I mean, the first thing, probably, that comes to people’s minds is, well, why is there even a Why is there such a thing? I know why there are 401K plans, 401K plans, get all the press out there, 403B plans, not so much. I know why 401K plans exist. Well, why do 403B plans exist? Well, partially the answer to our trivia question is a little bit of a clue is, 403B plans were around first! Which is the reason why they exist.
02:49
In fact, if 401k hadn’t been enacted, 403b would be the dominant model to make voluntary contributions to a retirement plan. 401k was enacted years after 403b, and like I said, that should give you a little clue to the trivia question and response that we’ll get to a little later. So it was here first. Secondly, the reason why it’s persisted, the reason why 401k didn’t come and just make 403b obsolete,
03:19
is you gotta understand 403B and for those of you not aware the basic definition of 403B is 401(k) plan for nonprofits is the short and sweet definition. So it operates very much like a 401K plan. There’s some important differences but it’s a 401(k) plan for nonprofits and public school districts are included in that definition. Healthcare, higher ed, whether private or public, museums, social welfare organizations.
03:49
Pretty much anything nonprofit that’s a charitable organization under 501(c)(3) of the code can have a 403b plan. So 403b has been around for a while, and we’ll tell you exactly how long in a few minutes. And when 401k came along, it didn’t impact 403b in terms of its survival all that much, because 403b’s were still very different when 401k was added to the code, even though they were both similar in that they both involved.
04:17
salary reduction or elective deferral pre-tax contributions. They had a lot of differences and a lot of those differences were advantageous to the nonprofit plan sponsors. If you want to think about the history of nonprofit organizations, a lot of the tax code made benefits more favorable to them because the concept was those individuals were getting less pay than their for-profit counterparts. So in order to attract people to not-for-profit organizations,
04:45
they had to incentivize them by creating benefits that were more favorable. So a lot of times, the rules for 403(b) plans are more favorable than for 401K and that was, there was far more so in evidence when 401K was first established. They’ve gotten more and more like each other over the years, but there’s still a lot of important advantages to 403 plans, again, based on the history of them coming out of nonprofit organizations. So what’s the differences between 401Ks or key differences?
05:15
a big, big one, is that testing is a lot easier. There’s no ADP or average deferral percentage test of elected deferrals. So in a 401k plan, it very much matters what the highly compensated employees defer to the plan. In 403 plans, it doesn’t. So that’s a big advantage because highly comps can pretty much put in whatever they want on the elective deferral side in a 403b plan and not have any issues where there’s testing that might restrict that in a 401k.
05:44
There’s also no top heavy testing in a 403B plan, so you don’t have to worry about that for a smaller 403B plan. Another big difference, 403B and 401K, is what’s called the universal availability requirement. It’s a requirement that generally all employees have the right to make elective deferrals with limited exceptions. Whereas in a 401K plan, you can make people wait a year before they make a deferral, and you can impose other types of restrictions. You can’t really do that in 403B plans with very, very limited exceptions.
06:13
It’s a good idea from a testing perspective to allow everybody the right to make elected deferrals. As we had alluded to before, another key difference is 401ks are available to everybody, including most nonprofits. Whereas 403Bs are restricted to certain tax-exempt organizations and public education institutions. They’re the only ones who can sponsor 403Bs. Investments in 403Bs are generally limited to annuities and mutual funds. Whereas 401k has a lot more types of investments. You can invest in individual stocks and securities.
06:42
in 401k plans and not in 403b so that’s a big difference. Another difference is assets are rarely invested in a trust in 403b plans. Whereas in 401ks that’s the common way they invest it in a group trust. 403b is much more common to invest in annuity contracts and custodial accounts. A lot of times those accounts can be a lot less portable than a trust. In a trust in 401k if you don’t like the trustee and possibly the relay record keeper you just
07:13
you just go to a new trustee. In 403B, that’s a lot harder to do. A lot of times there’s individual contracts that are owned by the participant where you can’t even change the form of investment in the contract without the participant’s consent. So that’s a very big, big difference between 403Bs and 401K plans. Another key difference is there’s a lot of legacy assets in 403B plans for the same reasons with the lack of trust. You have a lot of these individual contracts that are owned by the employees.
07:41
So you have lot of frozen or legacy assets, typically in 403B plans that are not controlled by employer. That of course affects your purchasing power and your ability to have lower fees, which is why just by every study you see, 403B plans have slightly higher fees than in the 401K plans. And a lot of that has to do with those legacy assets. Another big difference in 403B plans is multiple record keepers are not rare or not uncommon. In 401K plans, it’s extremely rare to see more than one record keeper in 403Bs.
08:10
I’ve seen plans with 50. They’re not common plays, but I’ve seen them and they’re not. A lot more common plays is I’ve seen plans with two record keepers. So again, not necessarily exclusive record keepers. There are another difference between 403Bs and 401Ks. Special contribution limits for church employees and employees with 15 years or more service. Although I generally hate the latter for reasons that will be probably the subject of a different podcast. I hate the 15-year rule.
08:40
election because it’s very complicated, but generally employees, church employees, can put more money in for the rebate plan. Another difference between the plans is there’s no employer contribution deductibility because think about it, these are nonprofits. They don’t pay taxes, so why do they need a deduction for their employer contribution? Another key difference is private tax exempts can actually elect to avoid ERISA for elected deferral only plans if certain rules are followed.
09:10
That’s not an option in 401k plans. So that’s another key difference. And the other ones are lesser differences. Post-retirement employer contributions can be provided, which can be a perk for people trying to phase people out of employment. Contributions pursuant to a one-time irrevocable election, whether or not to participate in plan, are subject to FICO withholding. In qualified plans, they are not subject to FICO withholding, but here they are.
09:38
And last but not least, there are actually what are called orphaned accounts in 403Bs that are actually not part of the 403B plan if they were established before a certain date. So you have assets that are not only frozen, you have also sometimes contracts that are not even part of your 403B plan, but there still might be a plan sponsor or plan participant relationship. That’s the big differences. You may say, well, that’s still lot of differences, but there were a lot more differences. were hundreds of differences 20 years ago. And you may say as 403B and 401K plans get
10:08
more more like, will 403(b) plans even be around? And my answer to that is they’ve had tremendous staying power so far, even though some of the differences have disappeared over the years, there’s still so many differences, I doubt we’ll see 403B plans disappear anytime soon. That is it in a nutshell. So there you go, got the basics of 403Bs and how they’re different from 401K plans, and we did that all in about 11 minutes or so. So about time to wrap things up here on this revamping retirement podcast, the answer to our trivia question.
10:38
When was Section 403(b) added to the Internal Revenue Code? The answer to that is 1958, over 60 years ago. And in fact that was 20 years before 401K was even added to the code. So as you can see, 403B plans have been around a long, long time. For Kara McCauley and our entire production team, this has been Revamping Retirement, Mike Webb signing off. Thank you for listening as always, and take care and I
11:07
Talk to you on the next episode of Revamping Retirement.
11:13
The content in this podcast is for institutional investors and plan sponsors. The information is intended to be educational and is not tailored to the investment needs of any specific investor. All examples of investor gains and losses are hypothetical and intended to illustrate the importance of early saving and consistent retirement contributions over time. Investment decisions should be based on an individual’s own goals, time horizon, and risk tolerance. Nothing in this content should be considered as legal or tax advice and listeners are encouraged to consult their own lawyer.
11:42
accountant or other advisor before making any financial decision. Thank you for listening to Revamping Retirement.