The 457(b) retirement plan is a tax-advantaged way to save for retirement that is designed especially for employees of state and local governments, as well as a few tax-exempt organizations. If you are employed by the federal government, you have access to a thrift savings plan instead of a 457(b) plan.
The 457(b) retirement plan is a good option for government employees looking to save for retirement, as it offers tax-deferred growth of their investments. However, there are some drawbacks to this type of plan that government workers should be aware of. Here is an overview of how the 457(b) plan works and what potential drawbacks to be aware of.
What is the 457(b)?
- A personal retirement savings plan provided to employees of state and local governments as well as tax-exempt organizations, such as charities and nonprofits.
- A tax-advantaged plan that allows you to contribute pre-tax dollars. Contributing pre-tax dollars reduces your taxable income each year, so you’ll pay less in federal income tax to the IRS. However, you will pay taxes when you withdraw the funds in retirement.
- A non-qualified plan, so you can invest in it at the same time you are investing in other plans, such as the 403(b). For physicians looking to maximize their retirement savings with tax-deferred income, it is best to max out the contributions to a 403(b) first and then contribute additional pre-tax money into a 457(b).
How does the 457(b) plan work?
A 457(b) allows workers to put away money into a special retirement account that provides tax advantages and lets the savings grow over time.
The employee contribution limit for those under age 50 is $20,500 for 2022, which is the same as 401(k) contributions. There is also a catch-up provision for those aged 50 and up that allows them to contribute an additional $6,500 each year.
There are two types of 457(b) plans: the pre-tax plan and the Roth plan. The pre-tax plan allows you to contribute money and take a tax deduction today, and then at retirement you’ll pay taxes when you take money out of the account. The Roth version of the 457(b) plan allows you to put in money after-tax-paying taxes on the contributions today- but in exchange you won’t have to pay tax on any withdrawals at retirement.
One of the best things about 457(b) plans is that you can start withdrawing money as soon as you leave your job, rather than having to wait until you’re 59 1/2. This makes it an ideal account to use for retirement income, or even sooner.
If you’re planning to leave your job, be aware that some employer-sponsored retirement plans have withdrawal rules that could cause a major tax issue. With a non-governmental 457b plan, you may be required to withdraw the entire amount within a very short time frame, which could create a difficult tax situation. Make sure you understand the withdrawal rules before you leave your job.
If you want to withdraw funds from an account such as a 401(k) before you are 59 ½ years old, you will have to pay a 10% early withdrawal fee, as well as income tax on the money you withdraw.
Different Types of 457(b) Plans
There are two different types of 457(b) plans: one for government employees and one for qualifying employees that are not directly employed by any form of government. They have many similarities, but there are some differences between the two.
Governmental Plans
The governmental 457(b) plans can be beneficial. They allow you to roll over funds into IRAs and other eligible retirement plans. You can also put contributions into a trust and take out loans if needed.
The government has plans that will allow you to make up for lost time if you are over the age of 50. With these types of plans from the government, they will only tax you on your contributions once you start receiving distributions from the plan.
Non-Governmental Plans
Non-governmental 457(b) plans do not allow you to roll over funds into another retirement plan, they cannot make contributions to a trust, and do not allow for catch-up contributions.
The other main distinction is that you will get taxed on the funds when they become available to you, even if the date of availability is prior to the date you start taking distributions.
How is the 457(b) Different From the 403(b)?
Both 457(b) and 403(b) plans can be offered to state and local government employees, as well as some employees of certain nonprofit and charitable organizations. High-level executives at nonprofit hospitals and charities may also be eligible to participate in these deferred compensation plans.
If you are employed in a certain position, you may be able to invest in two different things simultaneously.
If you are eligible to invest in both a 457(b) and a 403(b), it is important to understand how these two investment options differ and how they are the same.
The 457(b) and 403(b) have several things in common
A section of an employee’s salary is used to pay into both, which in some cases is matched by the employer. As of 2020, both of these plans have an annual employee contribution limit of $19,500 per year. Both of these are also designed to reduce your taxable income by having contributions made with pre-tax dollars.
In addition to the annual contribution limits, both plans allow you to make catch-up contributions if you are over the age of 50. As of 2020, the 457(b) allows you to contribute an additional $6,500 per year. The 403(b) allows for the same extra $6,500 contribution, but it allows for an added contribution of $1,000 per year.
If you have been with your employer for at least 15 years, you can contribute an extra $3,000 per year to your 403(b) plan, up to a total of $15,000 over the course of your employment with that company.
The Key Differences Between the 457(b) and 403(b)
There are many differences between 457(b) and 403(b) retirement plans, despite the fact that they have some similarities.
Fees for 457(b) plans may be higher
Most government employees have a pension, which means that a defined contribution plan like a 457(b) is seen as an extra savings plan. Therefore, employers rarely offer to match contributions.
457 plans don’t have employer matches, and they don’t do a good job of selling themselves, says Andrew Ness, a former consultant at Mercer Investment Consulting.
Since government employers don’t usually offer free money to workers to encourage them to sign up for the 457(b) savings plan, they may sign up for services that end up costing participants a little bit more but will encourage them to save.
Ness says that on-site education representatives are more common in the 457 market, where they visit to educate employees and enroll them in the plans.
Representatives can increase the fees that workers have to pay for 457(b) plans. However, there are other things that affect how much these plans cost workers, like the size of the plan.
Larger plans have more negotiating power than smaller ones when it comes to fees.
Ness states that providers (of small insurance plans) need to have a higher profit margin and as a result, fees are most likely higher as well.
Durand says that the plan administrator can make a difference in fees between a 457 and a 401(k). He says that it depends on who is in charge and if they are responsible for their fiduciary duties.
Employee Retirement Income Security Act (ERISA)
Retirement plans, including many 403(b) plans, are protected under ERISA.
The Employee Retirement Income Security Act protects your retirement savings from being seized in bankruptcy, through civil lawsuits, or through creditors to whom you owe money.
ERISA does not govern 457(b) plans. These plans do not offer the same protections as ERISA plans. Additionally, because they are not subject to ERISA guidelines, 457(b) plans may handle early withdrawals and hardship distributions differently.
Early Withdrawals
If you want to withdraw money from a 403(b) plan, you have to be at least 59 and a half years old. If you’re younger than that, you’ll have to pay a 10% penalty, on top of the taxes you owe.
457(b) plans allow you to make withdrawals at any age, as long as you have left the employer with whom you had the plan. Withdrawing early comes with no penalties, making it one of the best options for physicians who want to retire earlier than the normal retirement age.
Hardship Distributions
Different types of retirement plans handle hardship distributions differently. For example, it is more difficult to qualify for a hardship withdrawal from a 457(b) plan. In order to make a hardship withdrawal from a 457(b) plan, you must have an unforeseeable emergency.
A 403(b) plan is a less strict plan when it comes to the qualifications needed in order to make a hardship withdrawal from your account.
Employer Matching
The amount your employer can contribute to your plan varies depending on the type of plan. For example, employer contributions to a 403(b) plan are generally higher than those to a 457(b) plan.
With a 457(b), the employee and employer can contribute a maximum of $19,500 annually.
The employee has a maximum annual contribution of $19,500 for a 403(b), but the employer is able to contribute on top of that amount. In 2020, employers are able to contribute up to $37,500 with a total maximum contribution of $57,000 per year. Employer contributions like this are not typical, but they are allowed.
Should I invest In A 457(B) Plan?
If your employer offers a 457(b) plan, you should take advantage of it because it is a great way to save for retirement. The 457(b) plan offers tax benefits and encourages employees to grow their nest egg.
Pros of 457(b) plans
Some of the benefits of 457(b) plans include:
- A reduction of your adjusted gross income, which can help in lowering your tax bill and your student loan payments, if you are on an Income Driven Repayment Plan
- The ability to grow your investments tax-deferred
- Funds are only taxed at the point of distribution or withdrawal of funds in retirement
- Investors can withdraw funds before retirement when they stop working for their employer
Cons of 457(b) plans
- There may be fewer investing options than with 401(k)s
- Only available to certain employees employed by state or local governments or qualifying nonprofits
- Employer contributions count toward the annual limit
- Non-governmental 457(b) plans may be riskier
Prioritizing Saving For Retirement
No matter which retirement savings plan you choose, saving for retirement should always be a top priority. Saving as much as you can for retirement can help you to take advantage of compounding interest and grow your investments throughout your working career.
If you choose a 457(b) retirement plan, you should remember the differences between governmental and non-governmental plans. With a governmental plan, the money is held in a trust and can be rolled into other savings accounts. However, in a non-governmental plan, the money is controlled by your employer and can only be moved within other non-governmental plans. Non-governmental plans may be riskier, as your plan could be in trouble if your employer goes bankrupt.
The Bottom Line
There are more similarities than differences between 457(b) defined contribution plans and 401(k) corporate accounts, but the differences that do exist are crucial, and investors need to be especially mindful if they have both types of accounts.
Although you may already have retirement accounts which offer benefits, you can also open an IRA for additional retirement advantages. The Roth IRA is one of the most beneficial retirement accounts in America.
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