A 457b deferred compensation plan is a tax advantaged retirement plan similar to a 401k or a 403b plan. Just like those accounts a 457b allows you to save for retirement with pre-tax or after-tax (Roth) contributions. Although similar to the more widely known 401k and 403b, a 457b plan has a few differences you need to be aware of before incorporating it into your financial plan.
Key Points
- 457b plans are similar to 401k/403b plans. They allow you to make pre-tax contributions and invest those in a tax-advantaged plan.
- There are two main types of 457b plans: governmental and non-governmental plans. It’s important to understand the type of 457b plan you have because non-governmental plans have additional restrictions, and can be riskier than governmental plans.
- A 457b plan is an additional retirement account bucket you can fill up alongside your 401k/403b, providing you the opportunity to save an additional $22,500 in a tax-advantaged retirement account.
- 457b plans can allow penalty-free early withdrawals before reaching 59 ½. There are additional tax consequences to prepare for though, so have a plan for early withdrawals.
How is the 457b plan different from the 401k/403b
Most people are familiar with what a 401k and 403b plan are. They are very similar plans allowing you to contribute up to $22,500 (this is the limit for 2023, this amount can increase each year based on inflation) to a tax-advantaged plan for retirement savings. The 401k is offered to employees of for-profit companies and the 403b is offered by non-profit/governmental employers.
Within these plans you can make pre-tax or after-tax contributions, your earnings grow tax-free, and you can make withdrawals without penalty after you reach the age of 59 ½.
A 457b plan is typically offered by an employer as an additional retirement savings account in addition to a 401k/403b. Which is great because the contributions to your 401k/403b don’t count against your 457b contributions, and vice versa. With access to a 457b plan you could contribute an additional $22,500 each year to your tax-advantaged retirement accounts.
The key difference with a 457b plan
One main difference between a 457b plan and a 401k/403b plan is included in its full name: The 457b Deferred Compensation Plan. The money that you contribute to your 457b plan is considered deferred compensation and belongs to your employer until you withdraw it after leaving or retiring from your employer.
Another difference is that money can be withdrawn from a 457b plan much earlier without penalty than with 401k/403b plans. If you leave a job, and are younger than 59 ½, you have the option to begin withdrawing the funds from your 457b plan without the 10% penalty that you would face when taking an early withdrawal from a 401k/403b plan.
You need to be aware of the tax consequences of withdrawing from a 457b plan, because the withdrawals are treated as income (hence the name deferred compensation), and plans vary in their withdrawal options. Some funds force you to take everything in a lump sum which depending on the size of your 457b could cause quite the tax headache.
What are the two types of 457b plan?
457b plans are offered in two flavors and there are key differences between the two: governmental and non-governmental plans.
Governmental 457b plans
Governmental 457b plans are typically offered to employees of state and local governments. These are seen as a “less risky” version of the 457b plan since they are backed by the government rather than an individual business.
While you are an employee the money in your 457b is held in a trust. After leaving your employer, funds in these plans can be rolled over into an IRA or 401k, avoiding the possible tax headaches that come with distributions from a non-governmental 457b plan.
Non-Governmental 457b plans
Non-Governmental 457b plans are offered by non-profit employers such as hospitals, not state and local governments. These plans are considered riskier because the plans rely on your employer’s solvency, not the government.
With a non-governmental 457b plan, rather than making contributions out of your paycheck, contributions are made by your employer and it is technically money that you haven’t earned yet, hence the name deferred compensation. Rather than sitting in a trust as with a governmental plan, the 457b in this case still belongs to your employer, not you, until you transfer or withdraw the funds.
This can be helpful and protect you in the case of a personal bankruptcy, as your 457b funds belong to your employer and are not subject to your creditors (+ for asset protection). But the funds are also subject to your employer’s creditors in a situation where your employer goes under. This is not as big of a risk when it comes to an established hospital or company but is still something to consider.
Another potential downside for non-governmental 457b plans has to do with their distribution or rollover options. These plans can only rollover into another non-governmental 457b plan, and only in limited situations. That means that rolling over into a 401k or IRA is not an option.
When you leave an employer funds must be distributed within 10 years. Most 457b plans allow you to make distributions over 5-10 years, but some make you take a lump-sum distribution upon leaving your employer. A lump-sum, or even 5 years of distributions could create quite the tax headache if not planned for properly.
457b plan is a great early retirement tool
The 457b plan can be a great supplemental retirement savings account, but can be especially impactful for individuals pursuing early retirement. Having a 457b in addition to a 401k/403b doubles your annual contribution limit for retirement accounts, $22,500 => $45,000 in pre-tax or Roth contributions each year.
Because of their status as deferred compensation and the lack of an early withdrawal penalty, 457b plans can build a great bridge between your early retirement years and when you turn 59 ½ and can withdraw from your 401k/403b penalty free.
Should I contribute to my 457b, 401k, or 403b first?
When considering which retirement plans to contribute to, and which one you should focus on first, the 457b tends to come in as an afterthought when compared to your 401k/403b and IRA/Roth IRA accounts. This makes sense, as most people haven’t even heard of a 457b before finding out they have access to one.
The first account to fund should be whichever one is providing you an employer match. If your employer 100% matches the first 5% you put into your 401k, do that first. It’s hard to beat a 100% return on your money. After that it usually makes sense to max out your contributions to your 401k/403b before making additional contributions to your 457b.
All of the above recommendations may vary based on the available cash flow that you can contribute to these accounts, as well as the other tax-advantaged accounts that you have access to and want to fund to meet your goals: your HSA, 529 education account, IRA/Roth IRA, etc.
You will want to compare your available plans for any differences in investment options, fees, or vesting schedule (how long you need to remain at your company until the money is yours with no strings attached) before making your final decision.
Another difference with 457b plans is that you have a total contribution limit of $22,500 which any employer contributions also count against. Where employer contributions to your 401k/403b count against your total $66,000 contribution limit, and you can still contribute your full $22,500. It’s a minor difference, but still one to keep in mind.
In either case, the great thing with the 457b is that it resides in its own bucket and doesn’t impact how much you can contribute to your 401k/403b. Allowing you to contribute an additional $22,500 to a tax-advantaged retirement account.
401k and 403b Catch-Up Contributions vs 457b Catch-Up Contributions
401k and 403b plans allow individuals who are 50 or older to make additional catch-up contributions of $7,500 per year. The contribution limit for a 457b plan is doubled for the three years prior to the plan-specified retirement age. Based on current contribution limits you could make $45,000 in annual contributions in the three years before you retire.
Pros and Cons of 457b plans
Pros
- Provides another tax-advantaged retirement account bucket for you to contribute to
- Ability to make early withdrawals without penalty after you leave your employer
- Can roll funds in governmental 457b plans into another retirement account (401k/IRA)
- Allows larger catch-up contributions in the 3 years before the plan specified retirement age
Cons
- Riskier option compared to a 401k/403b if you are contributing to a non-governmental plan
- Can’t rollover a non-governmental plan into another retirement account (401k/IRA)
- Some plans have limited withdrawal options, such as requiring a lump sum withdrawal that could cause a major tax headache
- Can (sometimes) have less investment options available for you to choose from
Wrap up
A 457b plan is a great retirement savings tool to have access to, providing an additional bucket of tax-advantaged savings to contribute to outside of your 401k/403b. But before you start using your 457b you need to understand the type you have: governmental or non-governmental, along with other details to make sure it fits in your financial plan correctly.
Using a 457b plan correctly can help you turbocharge your retirement savings, and provide an income bridge for those pursuing early retirement. It’s hard to overstate the additional flexibility that a governmental 457b plan provides. With the option to early withdraw funds penalty-free or roll them over into another 401k/IRA, they are one of the best accounts out there.