Understanding the importance of ERISA 403(b) compliance testing

In the realm of retirement planning, 403(b) plans can be a valuable tool for employers of certain organizations to provide to their employees. However, to ensure the effectiveness and fairness of these plans, certain compliance testing is required. This guide delves into the intricacies of 403(b) compliance testing, shedding light on the required tests and rules that govern these retirement plans. 

Overview of 403(b) plans

Before diving into compliance testing, however, it's important to have a solid understanding of 403(b) plans. These plans are designed for employees of certain tax-exempt organizations, such as schools, hospitals, and religious organizations. They allow employees to contribute a portion of their salary to a retirement account on a pre-tax or post-tax basis. While pre-tax deferrals are made before taxes are taken out, Roth deferrals are made on an after-tax basis, meaning that contributions are deducted after taxes are taken out.

Coverage and compliance testing rules for 403(b) plans

403(b) plans have several unique characteristics. For example, 403(b) plans may allow for additional catch-up contributions for employees with at least 15 years of service. 403(b) plans may also offer the option to invest in annuities. Additionally, 403(b) plans benefit from simplified eligibility and compliance testing regulations.

Eligibility and universal availability

The cornerstone of 403(b) plans is the universal availability rule, requiring that most employees must be offered the chance to contribute, with few exceptions, such as students and employees working less than 20 hours a week. It's important to note that the introduction of long-term part-time (LTPT) rules in 2025 will further expand these eligibility criteria.

Simplified coverage testing

A key advantage of 403(b) retirement plans is that they benefit from simplified compliance testing. Generally, 401(k) plans must pass an actual deferral percentage (ADP) test to compare the average percentage of highly compensated employees (HCEs) deferrals against the average percentage of non-highly compensated employees (NHCEs) deferrals. Elective deferrals in 403(b) retirement plans are exempt from nondiscrimination testing, although plans that provide employer contributions must prove they do not favor HCEs.

Required nondiscrimination testing for 403(b) plans

Although they do not require ADP testing, 403(b) plans that provide matching contributions must typically conduct actual contribution percentage (ACP) testing. By comparing the average percentage of employer contributions between HCEs and NHCEs, the ACP test aims to prevent any disproportionate benefits. This involves calculating each employee's contribution ratio by dividing any matching contributions by their pay. 

Top-heavy testing exclusion of 403(b) plans

Unlike other retirement plans, 403(b) plans are exempt from top-heavy testing. This means that plan administrators do not need to evaluate whether the account balances of key employees (such as officers, owners, or those considered highly compensated) constitute more than 60% of the total account balances within the plan, nor provide minimum benefits to non-key employees when the plan is considered top heavy. This exemption is designed to simplify the administration of 403(b) plans and ensure a more straightforward path to compliance.

Importance of compliance testing for 403(b) plans

Compliance testing plays a vital role in ensuring that 403(b) plans adhere to the regulations set forth by the Internal Revenue Service (IRS). These tests are designed to prevent discrimination in favor of HCEs and to ensure that the plan meets certain coverage and participation requirements. By conducting compliance testing, plan administrators can identify any potential issues and take corrective action to maintain the plan's tax-qualified status.

If contributions to HCEs significantly exceed those of NHCEs, the plan may make a corrective contribution to the plan or provide refunds of excess employer contributions to HCEs. This may involve returning excess contributions to highly compensated employees or making additional contributions on behalf of non-highly compensated employees. Failure to correct the testing failures can result in the plan losing its tax-qualified status, which can have significant tax implications for both the employer and the employees.

401(k) vs. 403(b): Differentiating compliance testing needs

Both 401(k) and 403(b) plans are subject to regulatory compliance testing to ensure fairness and prevent discrimination in favor of highly compensated employees. However, the specific testing mechanisms differ between the two, reflecting their distinct regulatory frameworks and the entities they serve.

• 401(k) plans: These plans are subject to rigorous testing requirements, including the ADP and ACP tests, aimed at monitoring both employee deferrals and employer contributions. Additionally, they must often navigate top-heavy testing to ensure that key employees do not disproportionately benefit from the plan.

• 403(b) plans: While also committed to fairness, 403(b) plans are exempt from the ADP test, focusing instead on the ACP test for monitoring employer contributions. 403(b) plans are not subject to top-heavy testing, simplifying their compliance requirements.