“I work with an Employee Retirement Income Security Act (ERISA) 403(b) plan sponsor that has a 403(b) plan in which each participant owns an individual annuity contract. We wish to replace the 403(b) plan with a 401(k) plan. Can we terminate the 403(b) plan and start a 401(k) plan immediately afterward? Are there any special legal issues in terminating the existing plan or starting the new plan, considering that participants are not terminating employment?”

Charles Filips, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, vice president, Retirement Plan Services, Cammack Retirement Group, answer:

The final regulations do indeed permit termination of a 403(b) plan and subsequent establishment of the 401(k) plan (as an alternative, the 403(b) plan could simply be frozen with a 401(k) plan established for future contributions). There is a “successor plan” rule that would require a plan sponsor to wait 12 months before establishing a new “successor” retirement plan, but since a 401(k) plan is not considered a successor plan to a 403(b), those rules do not apply.

However, there are some other issues with terminating a 403(b) plan and simply replacing it with a 401(k), as follows:

1) The IRS plan termination procedures require that ALL assets of the existing plan be distributed before the plan is considered to be terminated. The 403(b) regulations state that “delivery of a fully paid individual insurance annuity contract is treated as a distribution.”  The IRS clarified in recent guidance that custodial accounts (mutual funds) can be treated in a similar fashion. You would want to follow that guidance as well as notify both the vendors and the participants that the contracts and accounts have been distributed. Be aware that the Department of Labor (DOL) has never issued its own guidance on 403(b) plan terminations, but over the last nine years since the IRS issued its guidance on 403(b) terminations, the DOL has not expressed any disagreement with the IRS approach, either.

2) Note that there is no requirement that 403(b) plan assets be rolled over to the new 401(k) plan. Plan termination is a distributable event, so active employees who would not otherwise be able to receive a distribution could elect to receive a plan termination distribution and use the funds for whatever purposes they desire (subject to the 10% tax on early distributions, for most distributions before 59 and 1/2). Such “leakage” from retirement plan assets, as it is called, is sometimes undesirable for two reasons: a) diminished retirement benefits for employees who utilize retirement plan assets for non-retirement purposes, and b) diminished purchasing power in the new 401(k) plan since it will not receive all assets from the existing 403(b) plan.

3) If the 403(b) plan is frozen (no new contributions, but assets remain), as opposed to terminated, all plan assets will continue to be fully subject to IRS and DOL (if ERISA-covered) regulations until distributed. This includes full annual 5500 reporting for ERISA plans, including an audit requirement for large ERISA plans, as well as all other applicable reporting and disclosure requirements and having to keep the plan documents up to date, just like a frozen 401(k) plan. Note that these requirements cannot be alleviated by merging the 403(b) plan assets into the new 401(k) plan, since such mergers are currently expressly prohibited (except for certain church plans). Thus, a plan sponsor would essentially be doubling its administrative effort by only freezing its ERISA 403(b) and replacing it with a 401(k) plan, as the 401(k) will carry administrative requirements of its own.

4) 401(k) plans contain a key drawback for nonprofits that employ any individuals who earned in excess of $130,000 (indexed) in 2020. Specifically, such individuals may be restricted as to the amount they may voluntarily contribute to the 401(k) due to a testing limitation known as the actual deferral percentage (ADP) test, which does not apply to 403(b) plans. Safe harbors are available to avoid ADP testing, but all are accompanied by the added expense of a required employer contribution. However, if no individuals who earn in excess of $130,000, otherwise known as “Highly Compensated Employees”, are employed by the institution, a 401(k) may be a more viable option in this scenario.

It is for these reasons that 403(b) plan sponsors should be cautious when exploring a 401(k) plan as a “replacement” for their 403(b), though there may be other valid reasons for a nonprofit to explore a 401(k) plan as an option.

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.