Can a 403(b) Be Added for HCE Deferrals to Help Pass Testing?

“I work with a health care organization that sponsors a 401(k) plan. The plan usually fails the actual deferral percentage (ADP) and actual contribution percentage (ACP) tests due to highly compensated medical staff and administration. They would like to set-up a 403(b) plan in addition to their 401(k) plan to defer any excess contributions by highly-compensated employees (HCEs) to the 403(b) plan. Is this strategy allowable under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code?”

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:

Assuming that your employer is eligible to sponsor a 403(b) plan (e.g. a 501(c)(3) charitable organization), the Experts don’t believe there is any reason why this organization couldn’t set up a 403(b) plan for additional deferrals. Generally, as long as your eligible employer allows all employees to make elective deferrals to the 403(b) under the universal availability rule under Internal Revenue Code Section 403(b)(12)(A)(ii), the employer should be able to sponsor a 403(b) plan. However, sponsoring a 403(b) plan likely wouldn’t necessarily help with passing ACP testing, since 403(b) plan sponsors that provide employee matching or employee after-tax contributions are generally required to perform ACP testing if they choose to match deferrals in that plan (which, as a practical matter, is unlikely, since it is already matching deferrals in the 401(k)).

The 403(b) is useful to address your ADP testing issues, since ADP testing is not required in a 403(b) plan. Of course, it would have been simpler if your employer established a 403(b) in the first place, so that ADP testing could have been avoided entirely, but it would likely be a more disruptive option now to terminate the 401(k) in favor of a 403(b).

Another idea is that the health care organization may wish to consider establishing a 457(b) plan for supplemental deferrals, if it has not established one already. If the entity is a private tax-exempt, participation in the 457(b) plan would be limited to select management or highly compensated employees, which may be the very individuals that are causing the 401(k) ADP testing to fail. In addition, this type of plan is a so-called “Top-Hat” plan that would not be subject to ERISA, so there should be less administration involved than for a 403(b) plan.

Finally, if all else fails, there are safe harbor plan designs that can be used to avoid ADP/ACP testing as well.

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.