403(b) Compliance Guide

Erik Daley, CFA
Managing Principal

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The 403(b) market has changed fundamentally over the last decade leaving many plan sponsors confused about their requirements in managing a qualified 403(b) plan.  The confusion has been amplified in that all 403(b) plans are not the same.  For example, 403(b) plans of Internal Revenue Code (Code) Section 3121(w) “steeple” churches or qualified church-controlled organizations (QCCOs) are not subject to any nondiscrimination testing.  403(b) plans sponsored by governmental entities are generally exempt from nondiscrimination testing, with the exception of the universal availability requirement under Code Section 403(b)(12) and compensation limit under Code Section 401(a)(17).

That leaves the 501(c)(3) entities sponsoring 403(b) plans.  Their potential testing obligations are detailed below.

Universal Availability Requirement Under Code Section 403(b)(12)

Under the universal availability requirement, all employees must be permitted to defer at least $200 per year under the plan through salary reduction elections.  The only employees who can be excluded from making salary reduction contributions are:

  • employees who are participating in an “eligible” 457(b) plan, a 401(k) plan or another 403(b) plan maintained by the employer;
  • non-resident aliens;
  • work-study employees; and
  • employees who normally work less than 20 hours per week1

Annual Compensation Limit Under Code Section 401(a)(17)

The Annual Compensation Limit restricts the total annual compensation that may be used when calculating contributions.  This limit is indexed by the Internal Revenue Service (IRS) and was $265,000 in 2016.  The participant may not earn benefits on any compensation he/she receives in excess the of the Annual Compensation Limit threshold.

Code Section 401(a)(4) Testing of Contributions and Benefits

Code Section 401(a)(4) provides that a plan is qualified only if the contributions or benefit provided under the plan do not discriminate in favor of highly compensated employees (HCEs).  There are three requirements a plan must meet to satisfy Code Section 401(a)(4):

  1. the contributions of the benefits provided under the plan must be nondiscriminatory in terms of their amount2;
  2. the benefits, rights, and features provided under the plan must be available to employees in the plan in a nondiscriminatory manner; and
  3. the effect of the plan in certain special circumstances must be nondiscriminatory.

Code Section 401(m) Average Contribution Percentage (ACP) Testing for Matching Contributions

The ACP rules require that the contributions for the HCEs3 be within a certain range of the average contributions for the non-highly compensated employees (NHCEs).  Under ACP, employer contribution rates are averaged by dividing each eligible plan participants’ employer contribution by their annual compensation.  These individual contribution ratios are then aggregated and averaged to find the overall ACP.  ACP is passed if the average of the eligible HCEs satisfies either the 1.25 test or the 2% spread test.

  • 25 Test – Average HCE % cannot exceed 125% of the average NHCE %.
  • 2% Spread Test – Average HCE % cannot exceed the lesser of:
    1. 200% of the average of the NHCEs, or
    2. the average of the NHCEs, plus 2%

Code Section 410(b) Coverage Testing

Coverage testing is designed to ensure that employers do not design their retirement plan in such a way that enables a greater percentage of benefits to be paid to their HCEs.  To pass this test, the sponsor must demonstrate that a qualified retirement plan (or plans) provides benefits to a significant percentage of a plan sponsor’s NHCEs relative to its HCEs.  To sponsor a 403(b) plan, the plan must benefit a ratio of HCEs to NHCEs that passes either one of two tests under Code Section 410(b):

  • Ratio Percentage Test4 or
  • Average Benefits Test5.

An employee is generally said to be “benefiting” under a plan if they are eligible to receive employer contributions.  Employees not receiving match contributions due to an elective failure to defer would still be considered as “benefiting” under the plan.


For plan sponsors, the requirements in managing a qualified 403(b) plan may present challenges. Not all 403(b) plans are alike; the differences offered can create confusion. With the various Code requirements, it is important that plan sponsors understand their obligations and execute them accordingly. For more information on 403(b) compliance, contact a Multnomah Group Consultant.


1 Treasury regulations under Code Section 403(b) state that an employee normally works fewer than 20 hours per week if and only if (1) the employer reasonably expects the employee to work fewer than 1,000 hours of service for the 12-month period beginning on the date of hire; and (2) for each 12-month period ending after the employee’s first anniversary of employment, the employee did work fewer than 1,000 hours for the previous year.

2 It is generally permissible for a plan to satisfy this requirement by showing that either the contributions or the benefits are nondiscriminatory.

3 An employee who is more than a 5% owner of the entity or who earns more than the HCE threshold ($120,000 for 2016 and indexed annually by the IRS) is considered an HCE.

4 A plan passes the Ratio Percentage Test if the percentage of NHCEs benefiting under the plan is equal to at least 70% of the number of NHCEs benefiting under the plan.

5 For plans that do not pass the Ratio Percentage Test, the Code provides an alternative Coverage Test known as the Average Benefits Test (ABT).  The ABT is actually two tests: the nondiscrimination classification test and the average benefits percentage test.  Both parts of the ABT must be passed in order to satisfy coverage testing.  

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