With several different choices available for you, each more confusing than the other, taking control of your retirement can seem like a near-impossible task. It can be an exhausting, overwhelming, and sometimes nauseating process — but we’re here to make that process easier for you to navigate through. Retirement savings are practically exclusively made up of individual contributions, making it extremely important that you know all of the savings options available to you.
While you may be familiar with other retirement saving tools like a 401(k), Roth IRA, or 403(b) plan, many doctors and government workers have access to another vehicle that, when used wisely, can really boost retirement savings while also improving cash flow in retirement. This remarkable option is known as a 457(b) plan.
Now, what exactly is a 457(b) plan, how does it work, and when does it make sense for you? Let’s find out.
What is a 457(b) plan?
A 457(b) plan is an employer-sponsored, IRS-sanctioned, tax-deferred savings account that allows you to make pre-tax contributions towards your retirement. You may have also heard of a 457(b) plan referred to as a deferred compensation plan — it’s the same thing, we promise.
A 457(b) retirement plan is similar to a 401(k) or 403(b) plan in that a 457(b) plan is offered through your employer and your contributions are taken from your paycheck on a pre-tax basis, which ultimately lowers your taxable income. Also, for both 401(k)/403(b) and 457(b) plans you can only contribute up to $19,500 per year in 2020. However, you can max out a 401(k)/403(b) AND your 457(b) in a given year. With a governmental 403(b), you essentially have an additional “403(b)” now.
However, a 457(b) plan has some wiggle room in regards to the contribution limit. Within a 457(b) plan, there are special catchup contributions, if permitted by the specific plan, designed to help you save more for retirement. They allow you to save enough for retirement, even if you may have started saving a little later than optimal. Note that catch-up contributions are only applicable if you are 50 or older.
Catchup contributions have the ability to allow a participant for 3 years prior to the plan specified retirement age to contribute to the lesser one of the following:
$39,000 (twice the annual limit of $19,500)
The basic annual limit plus the amount of the basic limit not used in prior years (age restrictions apply)
A great feature of 457(b) plans is that you don’t have to wait until you are 59 ½ to start withdrawing contributions. This unique part of this type of plan makes it a wonderful account for retirees to draw from at the very start of their golden years. For other accounts like a 401(k), you can’t withdraw any funds before 59 ½ without incurring 10% early withdrawal fees, as well as income tax on the distributions (we don’t make the rules, we just have to follow them).
There are two types of 457(b) plans to be aware of:
Governmental 457(b) plans
Non-governmental 457(b) plans
Governmental and non-governmental plans are both deferred contribution plans, but they have many different rules, regulations, and responsibilities that come along with them. Let’s take a better look at the differences between these two types of 457(b) plans.
The difference between governmental and non-governmental 457(b) plans
See — we told you we wouldn’t leave you in the dark! There are a few key differences you need to be aware of when it comes to governmental and non-governmental 457(b) plans. Simply put, governmental plans are backed by the government and non-governmental plans are backed by your employer. Non-governmental plans tend to carry more risk in general as the plan’s solvency hinges on the employer.
Non-governmental 457(b) plans are interesting in that the money contributed doesn’t come directly out of your paycheck, rather it is technically money that you haven’t yet received. Your employer owns the account and takes a percentage (that you indicate) that you would have received in a regular paycheck and instead contributes it to this fund.
This technically makes 457(b) plans belong to your employer and not to you, which saves you in the event of creditors or bankruptcy. Unlike a 401(k) that has more strict protections, 457(b) plans are subject to your employer’s creditors, which could leave your plan in jeopardy should the company go under. While this is not a likely situation if you are with an established company, it is something to consider.
In a governmental plan:
Funds can be rolled over into other accounts such as an IRA or 401(k) which can allow you more investment opportunities
The money is held in a trust
In a non-governmental plan:
Funds can only be transferred to or withdrawn from other non-governmental plans (i.e. if you leave your job, you could have to take a lump sum which could turn into a major headache)
Funds cannot be rolled over into other retirement savings accounts such as an IRA or 401(k)
Money is subject to your employer’s creditors; it is not held in a trust
As you can see, there are a few major differences between governmental and non-governmental plans. Your financial advisor will be able to help guide you in the right direction when it comes to your different investment options.
Why should you invest in a 457(b) plan?
The real question is, why wouldn’t you? There are two major benefits to investing in a 457(b) plan. The first reason is the numerous tax benefits this plan can offer you.
These tax benefits include:
A reduction of your adjusted gross income which can help in lowering your tax bill
Growing your investments, tax-free
Taxation only at the point of distribution or withdrawal of funds in retirement (similar to a 401(k))
A 457(b) plan also offers you another retirement savings tool, and prioritizing saving is vital to help you reach your other financial goals. A 457(b) plan is an excellent option to better prepare yourself for retirement, especially if you have access to a governmental plan. If you have other retirement savings accounts to consider, we will discuss that next.
How to coordinate your 457(b) plan with other savings vehicles
When you have other savings accounts, it can be difficult to make them work together, and not against each other. The first step to coordinating your savings accounts is to understand which type of 457(b) plan you have, governmental or non-governmental, and weigh the pros and cons of each.
Oftentimes with a governmental plan, it’s almost a no-brainer to invest in because there is less risk than that with a non-governmental plan. With a non-governmental plan, take a look at your investment options, distribution requirements, and financial stability of your employer when making your decision whether to invest or not. Evaluate your other accounts and ensure you and your financial advisor have a plan for how those work together.
These types of accounts include, but are not limited to:
Pro-Tip: You can max out a 401(k)/403(b) AND your 457(b) in a given year. This is an amazing feature to take advantage of if you have the opportunity. With a governmental 403(b), you essentially have an additional “403(b)” now.
It’s important to mention again that non-governmental plans cannot be rolled over into other savings accounts such as an IRA or 401(k), unlike governmental plans. This will greatly affect how your other savings vehicles will be able to work with each other.
Retirement savings should always be a priority
401(k), IRA, 403(b), or 457(b)— no matter which you choose, saving for retirement should always be a top priority.
If you do choose a 457(b) retirement plan, remember the differences between governmental and non-governmental plans. In a governmental plan, money is held in a trust and funds can be rolled into other savings accounts. In a non-governmental plan, the money is controlled by your employer and funds can only move within other non-governmental plans.
Looking for a more thorough all-in-one spot for your financial life? Check out our free eBook, A Doctor’s Prescription to Comprehensive Financial Wellness.
Written by Chad Chubb, CFP®, CSLP®