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457(b) Deferred Compensation Plan – How This Retirement Account Works

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As you grow older, retirement savings become more and more important. Most people who think about retirement accounts think about 401(k)s and individual retirement accounts (IRAs), but if you work for a state or local government or tax-exempt organization, chances are you already have or are considering a 457(b) plan. 

At face-value, 457(b) plans seem very similar to more traditional retirement savings accounts, but as you dig into the details, that notion changes. With 457(b) accounts, contributions, withdrawals, and how you can invest your retirement nest egg all have their own little quirks that you won’t experience with more other retirement savings options. 

What Is a 457(b) Plan?

457(b) plans are retirement accounts exclusively available to state and local government employees and employees of some nonprofit organizations. 457(b) plans are tax-advantaged and come in both traditional and Roth varieties. 

The traditional 457(b) is a deferred compensation plan, meaning you make contributions to the plan on a pretax basis, although you do pay income taxes when you retire and withdraw money from the plan. 

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When you make contributions to a Roth 457(b) plan, they’re made on a post-tax basis. So, you pay income tax on the money before contributions are made. However, your money grows tax-free. When you need to access the funds later in life, you don’t have to pay any income taxes. 

How 457(b) Retirement Plans Work

At first glance, 457(b) plans work like 401(k) and 403(b) plans in that they’re provided by your employer and come with tax advantages. You can have your employer contribute a percentage of your paycheck to the retirement account on a pretax (traditional contributions) or post-tax (Roth contributions) basis. 

Unlike other retirement savings plans, 457(b) plans have relatively limited investment options. You can only use these accounts to invest in mutual funds and annuities. You can’t invest in assets like stocks, bonds, exchange-traded funds (ETFs), and commodities in these accounts. If that’s not acceptable to you, you may want to consider a traditional IRA or Roth IRA instead. 

Also, many features and functions depend on your employer and the providers they use. Some 457(b) plans give you complete control over the mutual funds and annuities you invest in while others make the investment decisions for you.  

Another feature of 457(b) plans is that there are no early-withdrawal penalties. When you withdraw funds from IRAs and 401(k)s before you turn 59 ½, you pay the Internal Revenue Service (IRS) a 10% penalty. That’s not the case with the 457(b) plan. You can access the money penalty-free any time you’d like when you leave your employer. 

You may also be able to access your funds penalty free while you’re still with your employer, but that’s at the discretion of your employer and the plan provider. 

457(b) Contribution Limits

All tax-advantaged retirement plans have annual contribution limits. 457(b) plans are no different. The 457(b) maximum contribution for the 2022 tax year is $20,500, but you may be able to contribute more. If you’re 50 years old or older, you can make catch-up contributions, which add $6,500 to your annual deferral limit. 

You can increase your contributions even further when you’re within three years of your declared retirement age. At this point, you can contribute double the annual limit or 100% of your paycheck, whichever is less. So, if you’re three years from retirement in 2022, you can use the special three-year catch-up provision to contribute up to $41,000. 

If you add the double contributions and catch-up contributions with the 2022 maximum, you can contribute a total of $47,500. 

Also, if you have two employer-sponsored plans, you can contribute the employee maximum to both plans, which doubles your overall contributions. However, you can’t double-dip on catch-up contributions. You can only make those contributions on one plan per year. 

457(b) Withdrawal Rules

With most retirement plans, you can’t withdraw your funds before the normal retirement age, which is currently 59 ½. If you do, the IRS imposes a 10% early withdrawal penalty. 

That penalty doesn’t exist on 457(b) plans, but that doesn’t mean you can pull money out whenever you want. 

You only have open access to the funds in the account when you leave your employer. That’s great news if you retire before you’re 59 ½, but if you retire later, your money may be locked up longer than it would be in other account types. 

You may be able to access your funds in the event of an unforeseen emergency, but that’s at the discretion of your plan provider, and requests are often denied. If you are able to access your funds, it’s considered taxable income and you will have to pay income taxes on any amount you withdraw — that is, unless you have a Roth 457(b) account. 

It’s also important to keep in mind that these rules may not apply to rollover funds from other retirement investments. If you rolled money over from another retirement account that’s subject to traditional retirement investment rules and tax penalties, that portion of your 457(b) plan will likely still be subject to those rules. 

457(b) Required Minimum Distributions (RMDs)

You can’t keep money locked up in any employer-sponsored retirement plan forever, and 457(b) plans are no different. At some point, you will be required to take required minimum distributions (RMDs) from your account. 

In most cases, you’ll have to start tapping into the funds at age 72, but there is one exception to the rule. You don’t have any RMDs until the April after you retire. So, for example, if you continue working for the employer that sponsors the plan until age 75, you may not have to take your first required minimum distribution until you’re 76. 

Pros & Cons of 457(b) Plans

There’s good and bad in everything. Even batteries have positive and negative sides. 

OK, so I had a little fun there, but the reality is that no retirement investment plan is going to be the perfect fit for everyone. It’s important to weigh the pros and cons before diving into any retirement plan. After all, you don’t want to be stuck in a plan that doesn’t work for you until your golden years. 

Pros

If you qualify for a 457(b) plan, you’re in luck. There are several perks to this unique type of retirement account. If you’re like most people, your favorite parts of the plan may include:

  1. No Early Withdrawal Penalty. If you need to access your money and you don’t work for the plan sponsor anymore, you’re in luck. The lack of a penalty saves you 10%. If you are still employed by the plan sponsor, you can request an early withdrawal and if it’s granted, the money you receive is penalty-free.   
  2. Increased Contributions. Few retirement plans increase your contribution limits as you get closer to retirement age. 457(b) plans are an exception to the rule. After age 50 you can make additional catch-up contributions, and you can boost your contributions even more with a special three-year catch-up election right before you retire.
  3. Diversification. You can only invest in mutual funds and annuities in your 457(b) plan. Sure, that may seem like a limitation, but these tend to be some of the most diversified investment options on the market, which gives you protection in the long run.  
  4. Traditional & Roth Options Available. If you’d rather make pretax contributions, sign up for a traditional 457(b) plan. If you’d rather get the taxes out of the way today and enjoy tax-free access to funds in your golden years, go for a Roth 457(b).  

Cons

457(b) plans are exciting, but there are some drawbacks to consider before you decide to go for it. Some of the most painful drawbacks associated with these plans include:

  1. Limited Investment Options. You can only invest in mutual funds and annuities. Although this does bring the heavy diversification most financial advisors recommend into play, it also means you don’t have as many choices when deciding how you’ll invest your retirement savings. 
  2. Eligibility. 457(b) plans are only available to non-federal government employees and employees of some nonprofit organizations. If you’re not in one of these groups, you can’t open a 457(b). 
  3. Potentially Longer Lockup. You don’t have open-door access to your retirement savings until you don’t work for the employer that sponsors the plan anymore. So, if you work past 59 ½, your lockup period will be longer than it would be with an IRA or 401(k).  

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Should You Invest in a 457(b) Plan?

There’s no one-size-fits-all answer to this question. Whether you should invest depends on answers to a few questions about you:

  • Do You Plan to Leave Before 59 ½? Your 457(b) money may be locked up until you leave your employer. If you think you’ll stay later than the normal retirement age, but might need your money sooner, you may want to consider an IRA. If you think you’ll leave before the normal retirement age, a 457(b) might be the perfect fit. 
  • How Much Control Do You Want? Many 457(b) providers manage nearly every aspect of your investments for you. Those that let you choose your investments only allow you to select from a menu of mutual funds and annuities. If you like the more hands-off approach with limited options, 457(b)s are great. If not, a different retirement plan will be a better fit. 
  • Does Your Employer Offer 457(b) Plans? You can’t sign up for these plans as an individual. You must work for a government or nonprofit organization that provides them. 

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457(b) Plan FAQs

Retirement can be confusing because you have several different account types to choose from — each with its own requirements and limitations. Answers to some of the most common questions about 457(b) plans are below.

What’s the Difference Between a 457(b) & 403(b)?

457(b) and 403(b) plans are very similar, but they do have a few distinct differences. Those include:

  • Contribution Limits. Both plans have the same employee contribution limits, but with 457(b) plans, employer contributions count toward those limits. As a result, total contribution limits, including employer and employee contributions, are about double on 403(b) plans. 
  • Catch-Up Contributions. Both plans allow for catch-up contributions. 457(b) plans let you double contributions when you’re three years from retirement. 403(b) plans let you make additional contributions, up to $15,000 total, once you’ve worked for your employer for 15 years.
  • Withdrawals. 457(b) funds may be difficult to access while you’re still employed, regardless of your age, but can be withdrawn before you’re 59 ½ if you don’t work for the plan sponsor anymore. 403(b) plans follow traditional withdrawal rules, including penalty-free withdrawals starting at age 59 ½.

What’s the Difference Between a 457(b) & 401(k)?

457(b)s and 401(k)s are both employer-sponsored, tax-advantaged retirement accounts, but they’re also very different. The key difference includes:

  • The Employer. 457(b) plans are only available through government and nonprofit employers. 401(k)s are available through for-profit employers. 
  • Contribution Limits. 401(k) and 457(b) plans both have a $20,500 employee contribution limit and a $6,500 annual catch-up limit once you turn 50. However, 401(k) employers often make additional contributions that count toward different limits. When accounting for employer contributions, 401(k)s max out at $61,000. Also, you can’t double your contributions for three years prior to your retirement with a 401(k) like you can with a 457(b). 
  • Withdrawals. There’s no tax penalty for taking withdrawals before you’re 59 ½ with 457(b)s, but you’ll pay a 10% penalty to the IRS for early withdrawals from a 401(k). Withdrawals are penalty-free in a 401(k) once you reach 59 ½ regardless of who you do or don’t work for. By contrast, you don’t have complete access to 457(b) money until you don’t work for the plan sponsor anymore, regardless of your age. 

Do 457(b) Plans Offer Employer Matching?

There are no rules against employer matching in 457(b) plans, but employer plan contributions are rare with this type of account. 

Final Word

457(b) retirement accounts are unique investment vehicles that can help you make sure your golden years are indeed golden. Although there are plenty of perks to consider, there are also a few drawbacks. 

Carefully research your options and consider the comparisons between 457(b)s and 403(b)s and 401(k)s before making any final decision. Even if 457(b) plans are available, they may not be your best option. 

Nonetheless, if you’re looking for a simplified way to invest that provides immediate access to your retirement savings when you retire, regardless of your age, 457(b) plans might be the perfect vehicle for you. 

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