- 457 and 401k plans are both tax-advantaged retirement savings accounts offered through employers.
- 457s are offered by public sector or federal tax-exempt employers such as state and local governments while 401ks are offered by employers in the private sector.
- Although the two retirement plans are similar, the main difference is that 457 plans allow for higher contribution levels later in your career, and withdrawals before the age of 59 1/2 are not subject to a 10% penalty. Read more for the rules that apply.
Saving for retirement should be on everyone’s list of financial goals. However, the means available to reach your retirement savings goals can vary depending on your employer.
While 401ks and IRAs are the most common retirement accounts available in the United States, if you work in the public sector or other tax-exempt organization, you may have access to one of the lesser known retirement accounts — the 457 plan. Here, we’ll go over who has access to 457 plans, the regulations surrounding their use, and the pros and cons to saving your money in a 457 account as opposed to other common retirement accounts.
What Is a 457 Plan?
Much like a 401k, a 457 account is a tax-advantaged retirement account. Just as with a traditional 401k, participants in a 457 plan are able to deposit money in their 457 account and let the earnings grow without being taxed as long as the funds are in the account.
Just as with 401ks, 457s are offered by an employer as a defined contribution plan. However, in this case, the employer is a tax-exempt organization, usually a government entity or charitable organization (non-governmental entities tax exempt under IRC Section 501). A notable exception to the definition of charitable entities are churches and religious organizations; these employers can not offer a 457 plan under the IRS definitions of the plan.
Why Use a 457 Plan?
As mentioned above, a 457 plan is similar to a 401k in that it is a defined contribution plan. Participating employees can opt to have money taken directly out of their paycheck and placed in their 457 account. The primary draw to using this type of account to save for retirement is its tax-advantaged status, meaning that any money invested can grow tax-free while the funds remain in the account.
This tax-deferred status of the earnings means your money can work harder for you over the course of your career. For instance, say you choose to invest $6,000 today in your tax-deferred 457b plan and $6,000 in a taxable investment brokerage account. In this particular case, let’s say the funds earn an 6% annual return in both accounts.
Net Return of 6.0%
Net Return of 4.6%
In the case of your taxable brokerage account, let’s say you face a 24% tax on your returns each year. This means that your after-tax annual return on that fund is in reality 4.6%, rather than the full 6.0%.
Now, let’s look at how your 457b account performed. In your tax-deferred account, the $6,000 will earn the full 6% annual return. While a difference of 1.4% net return may not seem significant, as you can see in the chart above, it adds up over time. In fact, after 40 years, your 457b account will accumulate nearly double what you have in the taxable account.
Who Can Use a 457 Plan?
While most Americans are likely familiar with a 401k plan, the lesser known and much less common 457 plan is exclusively available to state and local government employees as well as employees at some nonprofits (except churches). For instance, a few job titles that would have access to a 457 retirement plan include:
- Public school teachers
- Police officers, firefighters and paramedics
- Municipal employees, like sanitation workers
- Government officials
- Nurses, doctors, and staff at nonprofit hospitals
Within the broader group of employees that are eligible for a 457 plan, there are two types of plan available based on income level.
- 457b: This plan is the most common of 457s and is offered to government employees as well as staff at some nonprofits.
- 457(f): This type of 457 is less known and less common. It is offered exclusively to highly compensated government employees as well as select nongovernment employees.
Now, if you find yourself in either of these groups of workers, it’s well worth your time to understand how a 457 plan works, as it can have a substantial positive impact on your ability to effectively save for retirement. However, because the 457b is by far more common, the information contained here will address the 457b in particular.
What Types of 457 Plans Are Available?
Just like a 401k plan, participating employees can choose to have money taken out of their paycheck each pay period and invested directly in their 457b account. Now, employees can choose to contribute pre-tax dollars to a traditional 457b plan, or after-tax dollars to a Roth 457b plan if the option is offered by their employer.
In the case of a traditional 457b plan, because the money is contributed before taxes are collected, that means the amount contributed is subtracted from the employee’s gross income. As such, this often results in an immediate lower tax burden due to a lowered income level. However, as with a traditional 401k, when you withdraw the funds from your traditional 457b, you will have to pay taxes on those withdrawals as if they were regular income.
On the other hand, with a Roth 457b, any money you contribute will be after taxes. That means you won’t get a reduction on your current taxable income. However, because you already paid Uncle Sam his fair share, when you withdraw the funds, you won’t have to pay any taxes on the amount you contributed. If you are at least 59 1/2 and your Roth 457b is at least five years old, the earnings are not taxed either.
How Does a 457b Plan Work?
Just as with other retirement accounts, 457b plans have certain rules and regulations that govern their operation. If you have access to one of these plans — whether you choose a traditional or Roth version — you’ll need to be aware of three main things:
- How much you can contribute: the 457 plan has a distinct advantage over 401ks
- How to rollover funds when you change jobs
- When and how you can withdraw
457b Contribution Limits
Just as with 401ks and IRAs, the Internal Revenue Service limits the amount you can contribute to your 457b each year. In 2019, the maximum amount was increased to $19,000 per year, up from $18,500 in 2018.
However, if you’re over the age of 50, the 457b features a catch-up provision that allows employees to contribute an additional $6,000 per year. Once you’re within three years of your plan’s full retirement age, you can contribute up to double the standard annual limit. For instance, say you were planning to retire at 65, “full retirement age” as defined by your 457 plan. Starting at the age of 62, you could put up to $38,000 per year in your 457b.
As you can see, your 457b account has great potential to help you toward your retirement savings. And as if that wasn’t enough, a lesser-known contribution rule for 457bs allows employees over the age of 50 to do something known as a “contribution rollover.”
For instance, if you contributed $10,000 to your 457b plan in 2019 at the age of 51 — rather than the $19,000 the plan allows — you could put in the full contribution amount for the next year ($19,000) plus the remaining $9,000 you didn’t contribute at age 51. In other words, you could contribute a total of $28,000 ($9,000 + $19,000) the following year at the age of 52. Note that you can only choose to contribute either catch-up amount of $6,000, the full $19,000 per year during the three years prior to retirement, or the unused contribution amount — so choose which amount is higher if you can.
Another quirk of 457b contributions is that employer-matched contributions count toward the maximum contribution limit, which is not the case for 401ks. So, say your employer contributes $3,000 to your plan. That means you could only add $16,000 for that calendar year. However, employer contributions are rare for this type of plan, so it’s likely not something you’ll need to worry about.
Huge 457 Advantage for Mega-Savings
Finally, it’s important to note that if your employer offers a 457b in addition to a 401k — which is common in some public sector agencies and tax-exempt organizations — you can contribute the full amount to both accounts.
Given that the annual contribution limit for 401k accounts is also $19,000 in 2019, that means you could save up to $38,000 in both accounts any given year. If you’re within three years of your plan’s full retirement age and take advantage of the full catch-up option in the 457, you could put away up to $63,000 (a contribution of $38,000 in your 457b + $19,000 in your 401k + $6,000 401k catch-up) in retirement savings into your two accounts.
For aggressive savers who have this much in income from their employer, these amounts can give a retirement nest egg a huge boost.
If you ever decide to leave the employer that provides your 457b plan, don’t worry. Whether you decide to move into another job in the public sector with an employer that offers a 457b or a private firm with a 401k, you can easily rollover your 457b balance into your new employer’s account. Note that Roth balances can only be rolled over into another Roth account.
As with a 401k rollover, a smart way to do a 457b rollover is to complete a direct transfer from your old 457b provider to the new retirement plan. This way, your new provider can help you navigate the bureaucracy involved in the transfer and ensure you avoid all possible tax consequences such as withholding and penalties.
All of the above should be outlined in your 457 plan documents, including any limitations or modifications that may be required by your employer. Consult with your HR department to confirm these details.
457b Withdrawal Rules
While the contribution rules for 457b accounts are similar to those of 401k accounts in 2019, it is the withdrawal rules that most differentiate 457bs from their 401k counterparts. In fact, 457b accounts offer great advantages when it comes to withdrawals.
In the case of a 401k, the IRS encourages employees to leave their money untouched until retirement age by imposing a 10% penalty on any 401k withdrawal before the age of 59 1/2. However, a 457b is completely free of this restriction but with strings attached.
If you need to withdraw money from your 457b account before you reach 59 1/2, you won’t have to pay any penalties but you do have to leave your employer (“separate from service”). To satisfy the IRS, you will have to pay regular income taxes on any withdrawals you make for the amounts in the Traditional 457 plan, and any earnings on your Roth 457 plan if you are under 59 1/2 or the account is less than five years old.
Which Retirement Account Should You Invest In?
If you work for an employer that offers both a 401k and a 457b plan, you can contribute to both. As such, it might be difficult to decide which plan you should contribute to. In an ideal world, you would be able to max out your contributions to both accounts. However, such a high savings rate just isn’t feasible for most people.
So, when choosing which plan to use — or what order to use them in — there are three factors that can help you decide.
1. Employer Matching
If you have access to both plans, check to see if either offers an employer match on your contributions. While such a match is uncommon for a 457b, when it comes to 401k plans, employers will match your contribution up to a certain amount. For instance, if you contribute 3% to your 401k each pay period, your employer might also contribute 3%, making your total contribution each pay period 6%.
If either account offers such a match, experts recommend contributing at least enough to that plan to capture your employer’s contribution. Employer matching is an employee benefit that should be taken advantage of.
2. Timeline for Withdrawal
As mentioned above, the rules surrounding withdrawals are the primary differentiator between a 401k and a 457b. If you anticipate you will need to tap into your retirement savings accounts before you hit 59 1/2 or would like to access your money in case of unforeseen emergencies, a 457b is a wise choice. However, if you think you can wait until retirement age to access your funds, either account will do just fine.
3. Contribution Amounts
As illustrated above, a 457 plan allows for much higher contributions once an employee nears retirement. With planning, taking advantage of those higher catch-up provisions can significantly reduce your taxable income during those years while providing your retirement savings with a significant bump in contributions.
4. Fee Structure
Once you’ve determined your employer matching opportunities, timeline for withdrawing your money, and the amount you can contribute, the final factor you should consider is the fee structure of your accounts. Depending on your investment options (many retirement accounts invest in high-expense mutual funds), you may have to pay a relatively high service fee for the management of your account.
Ask your HR team for documents that outline the fee structure for each plan or login to your account online. Then, direct your money to the account with lower fees to maximize your money’s growth.
Save Now, Relax Later
Saving for retirement should be high on your list of personal finance goals, no matter your job, your income level, or your age. So if you have access to a 457 plan, count yourself lucky. Taking full advantage of these accounts is a wise way to ensure you’ll have enough retirement income when you decide your working days are done. Save early and save often, and you’ll be able to enjoy your retirement years worry-free.