For workers in the public sector, pensions are usually the focus when it comes to retirement. Defined-benefit plans can be a great way to save for retirement. But many folks also have the option to contribute to a different kind of plan. These workers may not be able to contribute to a 401k (plan) through their employer, but they should still examine their retirement savings options. A pension is no guarantee of a comfortable retirement.
The public sector is probably the last bastion of the defined-benefit plan – that old-fashioned pension, calculated by the employer that came to employees automatically after they retired. But nowadays, no single source of income may be enough to ensure a comfortable retirement: People need to save on their own, too. Public-sector and non-profit organizations don't offer 401(k) plans that employees can contribute to. But they can and do offer other employer-sponsored plans: the 403(b) and the 457.
Here is an outline of both.
The 403(b) Lowdown
A 403(b) plan is typically offered to private-nonprofit employees and government workers, including public school employees. Like the 401(k), 403(b) plans are a type of defined-contribution plan that allows participants to shelter money on a tax-deferred basis for retirement. These plans were created in 1958, and were originally known as tax-sheltered annuities (TSA) or tax-deferred annuities (TDA) plans because they could only be invested in annuity contracts at that time. These plans are most commonly used by educational institutions, although any entity that qualifies under IRS Section 501(c)(3) can use this type of plan.
Contribution and Deferral Limits
The contribution limits for 403(b) plans are now identical to those of 401(k) plans. All employee deferrals are made on a pretax basis and reduce the participant's adjusted gross income accordingly. For 2017, the annual contribution limit (called the elective deferral) is the lesser of the employee's compensation or $18,000; for 2018, it's $18,500. An additional catch-up contribution of $6,000 is allowed for workers age 50 and above.
Notably, 403(b) plans offer a special additional catch-up contribution provision known as the lifetime catch-up provision, or 15-year rule. Employees who have at least 15 years of tenure and have contributed an average of $5,000 per year or less are eligible for this provision, which allows for an extra $3,000 payment a year. For more information on the 15-year rule, consult IRS Publication 571.
Employers are allowed to make matching contributions, but the total contributions from employer and employee cannot exceed $54,000 in 2017 ($55,000 for 2018). After-tax contributions are allowed in some cases, and Roth contributions are also available for employers who opt for this feature. Recent legislation has also allowed employers to institute automatic 403(b) plan contributions for all employees, although they may opt out of this at their discretion. Eligible participants may also qualify for the Retirement Saver's Credit.
When calculating 403(b) contribution limits for an individual, the IRS applies the limits in the following order: first, the elective deferral; second, the 15-year service catch-up provision; and third, the age 50 catch-up contribution. It is an employer's responsibility to limit contributions to the correct amounts. (For a complete 403 (b) plan guide, read our 403(b) Plan Tutorial.)
The rules for rolling over 403(b) plan balances have been loosened considerably over the past few years, and employees who leave their employers can now take their plans with them to another employer if they don't roll their plans over into a self-directed IRA. They can roll them over into another 403(b) plan, a 401(k) or other qualified plan. This allows employees to maintain one retirement plan over their lifetimes instead of having to open a separate IRA account or leave their plan with their old employer.
Notably, 403(b) plan distributions resemble those of 401(k) plans in most respects. You can start taking distributions at age 59.5, no matter if you’re still working at that organization or not. Distributions taken before age 59.5 are subject to a 10% early withdrawal penalty, unless a special exception applies. All normal distributions are taxed as ordinary income at the taxpayer's top marginal tax rate. Roth distributions are tax-free, although employees must either contribute to the plan or have a Roth IRA open for at least five years before being able to take tax-free distributions.
Mandatory minimum distributions, which are calculated according to the recipient's life expectancy, must begin at age 70.5, unless the plan is rolled over into a Roth IRA or other Roth retirement plan before then. Failure to take a mandatory minimum distribution will result in a 50% excise tax on the amount that should have been withdrawn. Loan provisions may also be available at the employer's discretion. The rules for loans are also largely the same as for 401(k) plans; participants cannot access more than the lesser of $50,000 or half of their plan balance, and any outstanding loan balance that is not repaid within five years is treated as a taxable or premature distribution. All distributions are reported each year on Form 1099-R, which is mailed to plan participants.
Many 403(b) plans are still funded with annuity contracts, despite the fact that the Employee Retirement Income Security Act (ERISA) permits these plans to invest directly in mutual funds. This is, in fact, a source of ongoing debate in the financial and retirement planning community, since annuities are tax-deferred vehicles in and of themselves, and there is no such thing as "double" tax-deferral. Most plans now offer mutual fund choices as well, albeit inside a variable annuity contract in most cases. But fixed and variable contracts and mutual funds are the only types of investments permitted inside these plans; other securities such as stocks, REITs and UITs are prohibited.
Importantly, 403(b) plans differ from their 401(k) counterparts in that they have no vesting provisions. However, they do now provide the same level of protection from creditors as qualified plans. Plan participants should also be aware of all of the costs and fees being charged by their plan and investment providers; the plan administrator must provide a complete breakdown of these fees to all plan participants.
The 457 Option
A 457 plan has two types. A 457(b) is offered to state and local government employees, while a 457(f) is for highly-paid non-profit employees. For a 457(b) plan, you can contribute up to $18,000 in 2017 ($18,500 in 2018) and an additional $6,000 if you’re older than 50. If you’re within three years of normal retirement age (according to your plan) then you may contribute up to $36,000. There’s also another catch-up option. According to the Internal Revenue Service (IRS), you may contribute, “the basic annual limit plus the amount of the basic limit not used in prior years (only allowed if not using age 50 or over catch-up contributions).”
The 457(f) plan requires that the employee work until an agreed-upon time. If the employee leaves before that date, they forfeit their right to the 457(f) plan. This plan is usually only offered to select members of an organization. Because the employee has to fulfill certain requirements to receive their 457(f) at retirement, the plan remains in the hands of the company. If you have a 457(f) plan, you’re eligible to contribute up to 100% of your income. This is primarily used as a powerful benefit and recruiting tool to find talented executives. Unless you can realistically imagine being head of a non-profit, you’re unlikely to run into this plan in your career.
One of the best benefits of the 457(b) is that it allows you to put double the amount toward your retirement plan. If you’re within three years of normal retirement age (according to your plan), you may contribute up to $36,000 in 2017, $37,000 in 2018. This is a greater catch-up provision than even 403(b)s provide. You can also put in an extra $6,000 if you’re at least 50 years old.
If you’re still working at a job where you have a 457(b), you can’t take any deductions until you’re at least 70.5 years old. However, if you are no longer working there, you can take the distributions at any time no matter your age. “You can take your money before you are 59.5 years with a 457 without any penalties, unlike any other retirement plan out there,” said Assistant Professor of Finance and Financial Planning Inga Chira, of California State University, Northridge. “That’s a big deal.”
If you leave your job, you can also roll over your account into an IRA or 401(k) – though this is only an option for the 457(b) plan, not the 457(f) plan. Unlike the 401(k), which only offers the 457(b).
Unlike the 401(k), whatever match your employer contributes will count as part of your contribution. That means if your employer contributes $8,000, you can only contribute $10,000 (unless you’re participating in a catch-up strategy). If you’re used to a 401(k), you might already be aware that the $18,000 limit only applies to employee contributions. The silver lining is that governments rarely provide matching programs within the 457(b) plan. It’s mostly up to the employees to make sure they’re saving an adequate amount.
How to Choose
If you need more time to put aside money for retirement, a 457 plan is best for you. It has the better catch-up policy of the two and will allow you to stash away more money for retirement. However, if you want a larger amount of investment options to choose from, a 403(b) is likely to be your best bet. “Although a 457 can also have multiple providers, usually, the choice of providers is not as wide as a 403(b),” Chira says.
There’s a potential third option as well: If you’re eligible for both plans, you can contribute to both. That means you can put away $38,000 in 2017, $39,000 in 2018, not including any catch-up contributions if you’re eligible. “This is especially appealing to employees who have great income and are trying to minimize their taxes,” notes Chira.
The Bottom Line
Don’t completely rely on that pension to provide for your retirement. Take your financial future into your own hands with a 457 or 403(b). If you have more questions about the plans available to you, contact your agency’s human resources department or your plan’s provider. They’ll be able to shed more light on your particular situation.