401(k), 403(b), 457(b): Why Are the Rules Different?

Posted By: Maria Hurd, CPA

Why Ask Why?

Why should the rules that determine how and how much a person can save for retirement be different depending on whether the person works for a government entity, a nonprofit, or a for-profit employer? People are people, and their retirement needs are not different based on what type of entity employs them. Well, it is what it is and we cannot control it, so we may as well embrace it. After all, the unnecessary complexity gives us pension professionals job security and variety is the spice of life!

A Walk Down History Lane

For those not buying that variety is the spice of life, perhaps a little history of when the three types of retirement arrangements came to be will help with acceptance. Code Section 403(b) came first. In 1958, Congress made available a tax deferred savings device for employees of certain section 501(c)(3) organizations by adding section 403(b) to the Internal Revenue Code. Although deferred compensation plans for municipal employers had already existed for over a decade, Section 457(b) of the Internal Revenue Code was created with the passage of the Revenue Act of 1978, which also added Code Section 401(k) to allow employees to defer taxation on elective deferrals. Although the 401(k) was intended for taxable employers, it was also used by some municipal employers. Later, the Tax Reform Act of 1986 prohibited the establishment of new 401(k)’s for municipal employers, reinforcing the 457(b) as the primary defined contribution savings vehicle for most municipal employers. However, municipal employers with established 401(k) plans were grandfathered. That’s the story of when they all started, but where are we now?

What are the Basic Differences?

Like Neapolitan ice cream, 401(k), 403(b), and 457(b) are just three flavors of the same product. The following chart summarizes some of the main differences between the three:

401(k) 403(b) Governmental 457(b)
Eligible Employers Few Restrictions-Employers cannot offer a SIMPLE IRA and a 401k simultaneously. Grandfathered government plans only. 501(c)(3) Organizations, Public Schools, Ministers, Dual Status Governmental 501(c)(3) Organizations State, Political Subdivision, Agency, or Instrumentality of a State
Title 1 of ERISA Yes, but not if it’s a governmental employer or a church Yes, but not if it’s a salary-reduction-only NON-ERISA plan, a governmental employer or a church No
Trust Requirement Yes No Annuity or Custodial Accounts Yes
2022 402(g) Elective Deferral Limit $20,500 One limit per year per person $20,500 Separate Limit
2022 Special Catch-up Limit No $3,000/yr, up to $15,000 or until average lifetime contributions = $5,000 per year of service. 15 years of service minimum No
2022 Age 50 Catch-Up $6,500 $6,500 $6,500
403(b) Post-Severance Contributions No Employer contributions for 5 years after employment ends based on includible compensation in the last year of service up to IRC Section 415 limit No
457(b) Special Catch-Up No No

Three years before Normal Retirement Age, the maximum special catch-up amount is the LESSER of:

  1. Twice the current year’s maximum, or $35,000 for 2013 or
  2. The underutilized maximum amounts for prior years
Universal Availability No Yes No
ADP Testing Yes, but not for grandfathered governmental employers No No
ACP Testing Yes, but not for grandfathered governmental employers Yes, but not for grandfathered governmental employers No
Hardship Distributions Yes Yes, sources limited Unforeseeable Emergencies

401(k) and 403(b) and 457(b)…. Oh my!

Unlike lions and tigers and bears or chocolate, vanilla, or strawberry, these plans are not so scary to administer or to audit once you get a good grasp of the main differences. Retirement plan arrangements, contribution formulas, and investment options are likely to continue becoming more complicated. Legislation to establish only one type of retirement plan arrangement is not in our future, so as pension professionals, we can help participants understand that the plan they have is not too this, or too that, it’s just perfect, so if they can’t have the choices they would have loved, they can learn to love the plan they’re with and just save!

 

Photo By: Joanne Goldby (License)