(b)lines Ask the Experts Replacing a 403(b) with a

401(k)
A plan adviser asks what are the rules, pros and cons of starting up a new 401(k) and freezing 403(b) and
457(b) plans.
Michael A. Webb,Vice President, Retirement Plan Services, Cammack LaRhette Consulting, answers:
First of all, let's address the 457(b) plan. The 457(b) plan, for the vast majority of 403(b) plan sponsors is a
supplemental plan designed for deferral in excess of those that can be contributed to the 403(b) plan. Thus, it would
not be "replaced" at all by a 401(k) plan, which is a plan similar in structure to a 403(b) plan. Should a 401(k) plan
be maintained in the future, the 457(b) plan would remain for supplemental deferral opportunities.
As for the 403(b) plan, 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. However, there are many issues, with this approach, as follows:
1) Though the IRS provides for a plan termination procedure in the final 403(b) regulations, DoL guidance is less
clear. Thus, if the 403(b) plan is subject to ERISA, you could have a situation where the IRS plan termination
procedure were followed, but the plan was not considered terminated for ERISA purposes, which would not be a
desirable situation - similar to a "frozen" plan as described below.
2) 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." However, it is not clear whether that also applies to 403(b)(7) custodial accounts,
or whether those must be actually distributed in cash (IRS representatives in the past have informally suggested the
latter). Moreover, again, the DoL has not indicated whether they agree with the IRS regulation on this, so if ERISA
applies, the uncertainty is magnified. And if that were not enough, if actual distributions are required, many annuity
contracts and custodial agreements with the plan vendors are constructed in such a way that only the individual
employee, NOT the employer, has the right to direct distribution of plan assets. Thus, in order to terminate the
403(b) plan, the employer may need to convince each and every plan participant, many of whom may no longer
work for the employer, to distribute their account balances (at least those held in 403(b)(7) custodial accounts, and
also assuming, if ERISA applies, that the DOL agrees), an impossible task for all but the smallest of plan sponsors. In
addition, charges for such distributions may apply.
3) Even if a successful plan termination can be accomplished, 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, at it is called, is 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.
4) 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. Thus, a plan sponsor would in this case essentially be

doubling its administrative effort by "replacing" its ERISA 403(b) with a 401(k) plan, as the 401(k) will carry
administrative requirements of its own.
5) 401(k) plans contain a key drawback for nonprofits that employ any individuals who earned in excess of $110,000
(indexed) in 2009. 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 Average Deferral Percentage, or 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 $110,000, otherwise known as
Highly Compensated Employees, are employed by the institution, a 401(k) may be a 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 401(k) as an option.