What Is IRS Notice 89-23 for 403(b) Plans?

The Internal Revenue Service (IRS) issued Notice 89-23 to provide transitional guidance for employers managing 403(b) retirement plans. This notice became necessary after the Tax Reform Act of 1986 introduced new nondiscrimination rules for these plans. Since final regulations explaining how to apply these tests were not yet available, Notice 89-23 established a “reasonable, good faith compliance” standard for employers to follow.

The notice also provided specific, optional safe harbor tests that, if met, would automatically satisfy this good faith standard. These rules were intended to bridge the gap until more comprehensive regulations were issued. The rules in the notice were eventually superseded by final regulations issued in 2007, which became effective in 2009.

The Good Faith Compliance Standard

The core of Notice 89-23 was its establishment of a “reasonable, good faith interpretation” standard for plan compliance. This standard required an employer to operate its 403(b) plan based on a plausible and defensible understanding of the nondiscrimination requirements mandated by the Tax Reform Act of 1986. It was a principles-based approach, acknowledging that without final, detailed regulations, employers needed flexibility to interpret the new statutes.

An employer’s interpretation did not have to be perfect, but it needed to be reasonable under the circumstances. This meant that an employer could not simply ignore the nondiscrimination rules; they had to make a sincere and documented effort to apply them fairly across their workforce. The standard was designed to prevent blatant discrimination in favor of highly compensated employees while the IRS finalized the operational details of the new law.

The good faith standard was not a license for inaction. Employers were expected to analyze their plan’s contribution structure and make necessary adjustments to align with the principles of the 1986 Act.

Safe Harbors for Compliance

To give employers a more concrete way to satisfy the good faith standard, Notice 89-23 outlined three specific safe harbor tests. Meeting any one of these safe harbors provided a guarantee of compliance with the nondiscrimination rules for nonelective and matching contributions. These tests offered a clear, mathematical alternative to the more subjective good faith interpretation standard, giving plan sponsors a defined target for their contribution formulas.

The first and most flexible option was the “maximum disparity safe harbor.” Under this test, an employer could make larger contributions for highly compensated employees (HCEs) than for non-highly compensated employees (NHCEs), but within strict limits. The contribution percentage for any HCE could not be more than 1.4 times the average contribution percentage provided to all NHCEs.

A more restrictive option was the “lesser disparity safe harbor.” This test also permitted a disparity in contributions but imposed tighter constraints. To qualify, the plan had to cover a broad base of non-highly compensated employees, and the contribution percentage for any single HCE could not be more than the lesser of 1.4 times the average for NHCEs or 3 percentage points higher than the NHCE average.

The simplest and most straightforward option was the “no disparity safe harbor.” Under this test, an employer was not required to make contributions for all employees. However, if an employee received a nonelective or matching contribution, the contribution percentage had to be the same for all participating employees, regardless of their compensation level.

Employers Subject to the Notice

The guidance in Notice 89-23 was directed at specific types of employers eligible to offer 403(b) plans. Primarily, this included public education institutions, such as public schools, colleges, and universities. It also applied to most tax-exempt organizations classified under Internal Revenue Code Section 501(c)(3).

The nondiscrimination rules, and therefore the compliance pathways offered by the notice, applied to employer contributions, not employee salary deferrals. Employee contributions were governed by the universal availability rule, which generally required that if any employee could make a salary deferral, all employees must be given the opportunity. Notice 89-23 did allow for the exclusion of certain employee groups from this requirement, such as those who normally worked fewer than 20 hours per week.

A significant exception to these rules was made for churches and certain qualified church-controlled organizations. These entities were explicitly exempt from the nondiscrimination testing requirements that applied to other 403(b) plan sponsors.