What do you envision when you think about retirement? Do you consider all the ways in which you might travel the world, lounge in your backyard pool, go sailing or fishing? Do you envision reading books to your grandkids or moving to another country?
Whatever your dreams, they may start with a 457(b) plan.
What’s a 457(b) deferred compensation plan?
Let’s find out. We’ll also go over the details about how a 457(b) works, who should participate, the advantages and differences between other types of retirement savings plans.
What Is a 457 Plan?
You may think of a tax-advantaged 457 plan as a state or local government employee’s version of the 401k. For example, if you’re a municipal worker, civil servant, law enforcement officer or other public safety worker, you may be eligible to invest in a 457 deferred compensation plan.
The true definition of a 457 plan: It’s a non-qualified, tax-advantaged defined-contribution retirement plan. Let’s take a look at the word “non-qualified” for a second. Unlike 457 plans, 401k plans are considered “qualified.” However, 457(b) plans are not governed by the same laws and regulations as 401k plans and 403(b) plans, which also means they offer more flexibility.
As mentioned above, 457 plans are tax advantaged, which means that they offer specific tax advantages. “Defined contribution” means that you contribute to these plans through payroll deductions.
There are two types of 457 plans: 457(b) plans and 457(f) plans. 457(b) plans are the most common (and the type described above). Government and select non-government employees in senior positions can tap into a 457(f) plan.
How Does a 457(b) Plan Work?
Contributions to your 457(b) are deducted from your paycheck. Contributions to a 457 come from your gross income and reduce your taxable income.
You may find that you’re somewhat limited in your investment choices. You can choose from annuities and mutual funds but can’t buy exchange-traded funds (ETFs) or individual stocks through a 457 plan.
You can grow your money tax-deferred until you withdraw it in retirement. At that point, it’s taxed as income.
When you’re ready to retire, you can withdraw some or all of your funds even if you haven’t yet turned 59½ years old. You won’t pay a 10% penalty for early withdrawals but will owe income tax on the amount you withdraw. However, you must take the money out at age 72 due to the IRS required minimum distribution (RMD) rule.
Who Should Participate in a 457(b) Plan?
You must work for a state or local government in order to qualify for a 457(b) plan. Firefighters, police officers, first responders, municipal workers and others may qualify. Most non-federal government workers qualify for a 457 retirement plan.
Advantages of a 457(b) Plan
In addition to the tax advantages of a 457(b) plan, they also offer the following features.
A double limit catch-up provision: The double limit catch-up provision allows participants to make up for years that they didn’t contribute to the plan but could have done so. Employees can contribute up to $39,000 to a plan in 2021.
Not subject to the 10% penalty tax: You won’t have to pay the 10% penalty if you take your money out before age 59 ½ like with many other types of retirement accounts. This can be helpful if you retire earlier than usual.
Catch-up contribution: In addition to the double-limit catch-up provision, you can also make catch-up contributions of $6,500 if you’re 50 or older, as mentioned above.
457(b) Plans and Employer Matching
If your employer offers a 457(b) plan, it may not match contributions. If a government employer does make a contribution to a 457(b) plan, it counts toward the total allowable limit for the year.
457(b) Contribution Limits
You can contribute $19,500 to a 457(b) plan in 2021, and that limit includes both employer and employee contributions. Note that employers usually don’t contribute to 457(b) accounts. Just like with a regular 401k, individuals 50 and older can make catch-up contributions of $6,500, which amounts to $26,000 in 2021.
401k vs. 457(b)
What’s the difference between a 401k and a 457(b)? Both types of plans are tax-advantaged and allow you to contribute money on a tax-deferred basis. You can also contribute up to $19,500 with a catch-up contribution of $6,500 for both of them.
Let’s take a look at a few differences between the two:
Type of employer: Private, for-profit employers traditionally offer 401ks, unlike public employers who offer 457(b)s.
Employer match: Employers more commonly match 401ks but not 457(b)s.
Minimum standards: 401ks are also subject to the Employee Retirement Income Security Act (ERISA) of 1974, which sets minimum standards for retirement plan participation, vesting, benefit accrual and funding.
Penalty for early withdrawals: Unlike a 457(b), you’ll pay a 10% penalty for early withdrawals from a 401k, on top of regular income tax.
Can You Have Both a 401k and 457(b)?
You can contribute to both a 401k and a 457 plan at the same time and maximize your retirement savings.
403(b) vs. 457(b)
Similar to 457(b)s, 403(b)s are also offered to public sector employees and certain employees of nonprofit organizations, such as private colleges and churches. Like 457(b) accounts, a 403(b) is a tax-advantaged retirement plan. 403(b) accounts also let your investments grow tax deferred or tax free over time. Also, they both offer rather limited investment offerings — typically, just annuities and mutual funds.
However, you can point to a few differences between the two:
Catch-up contributions work differently: While a 457(b) allows for double-the-limit contributions, a 403(b) allows you to make additional contributions if you’ve worked for the same employer for 15 years — up to $15,000 total.
Withdrawal treatment: 403(b) plans allow standard, penalty-free withdrawals at age 59 ½, as well as limited early withdrawal exceptions.
Can You Have Both a 403(b) and 457(b)?
Yes, you can contribute to both. Tax laws allow you to contribute to both types of plans and not have contributions to one make a difference in the amount you can contribute to the other.
Should You Pick a 457(b) or a 403(b)?
In general, 457(b)s offer a better catch-up policy, particularly if you’re saving in your later years, but a 403(b) might fit best if you want to be able to choose from a larger selection of investment options.
If your employer offers a selection of 403(b) and 457(b) vendors, determine which types of investment products work best for you. Learn more about how your plan operates by reading the plan materials, and learn about the background information on your vendor. Learn about the fees you’ll pay for each investment option, including fees and commissions.
Compare all your options before you make a final selection and investment decision.
Can a 457(b) Plan Include Designated Roth Accounts?
Your organization may also offer the option to contribute to a Roth 457(b). In this case, you fund your account with after-tax money so you can take advantage of tax-free withdrawals on qualifying distributions when the money is withdrawn in retirement.
You can contribute $19,500 to the Roth 457 (or $26,000 if you are age 50 or over). Would it be beneficial to contribute to a Roth IRA instead of a Roth 457? You can contribute more on an after-tax basis to your Roth 457 than to a Roth IRA. You can only contribute $6,000 to a Roth IRA in 2021 (or $7,000 if you are 50 or over) compared to the much larger Roth 457 contribution.
Is a 457(b) Right for You?
457(b) plans offer a plethora of options, but they also have a few downsides — particularly because most of them don’t offer the option to tap into a match from an employer.
When you envision your perfect retirement, you want to make sure the vehicle you select can offer you exactly what you want in the future.
Personal Capital can help you come to an informed decision.
Get the Personal Capital Retirement Planner, a tool in an award-winning suite of financial tools that enables you to determine how much money you should save for retirement.
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Author is not a client of Personal Capital Advisors Corporation and is compensated for the content contained in this article.
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