457 Plan vs. 403(b) Plan: An Overview
The public sector may be 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 also need to save on their own. Public-sector and nonprofit organizations don't offer 401(k) plans that employees can contribute to. However, they can and do offer other employer-sponsored plans: the 403(b) and the 457.
- A 457 plan has two types. A 457(b) is offered to state and local government employees, while a 457(f) is for top executives in nonprofits.
- A 403(b) plan is typically offered to employees of private nonprofits and government workers, including public school employees.
- There’s also a third option: If you are eligible for both plans, you can split your contributions between them.
The 457 Plan
A 457 plan has two types. A 457(b) is offered to state and local government employees, while a 457(f) is for top-level nonprofit employees.
For a 457(b) plan, you can contribute up to $19,000 in 2019 and $19,500 in 2020. You can also contribute an additional $6,000 in 2019 if you’re age 50 or older, and that limit goes up to $6,500 in 2020. If you are within three years of normal retirement age, then you may contribute even more. You may be able to contribute as much as $38,000 in 2019 or $39,000 in 2020. However, your maximum contribution when you are within three years of normal retirement age is limited by previous contributions. This limit is, according to the IRS, "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 date. If the employee leaves before that date, the 457(f) plan is forfeited.
This plan is usually only offered to top executives of an organization. Because the employee has to fulfill specific requirements to receive the 457(f) at retirement, the plan remains in the hands of the company. This plan is primarily a recruiting tool to lure talent that would otherwise stay in the private sector.
If you have a 457(f) plan, you’re eligible to contribute up to 100% of your income.
Unless you become the head of a nonprofit organization, you're unlikely to run into the 457(f) plan.
- One of the best benefits of the 457(b) is that it allows participants to put double the amount into the retirement plan. If you’re within three years of your plan's normal retirement age, you may contribute up to $38,000 in 2019 or $39,000 in 2020.
- This catch-up provision is even better than 403(b)s. You can also put in an extra $6,000 per year in 2019 if you’re at least 50 years old, and that amount rises to $6,500 in 2020.
- If you’re still working at a job where you have a 457(b), you can’t take any withdrawals until you are at least 70½ years old. If you are no longer working there, you can take the distributions at any age.
- “You can take your money before you are 59½ years old 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). However, this is only an option for the 457(b) plan, not the 457(f) plan.
- Unlike the 401(k), the match your employer contributes will count as part of your maximum contribution. If your employer contributed $9,000 in 2019, then 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 $19,000 limit there applies only to employee contributions.
- It should be noted that few governments provide matching programs within the 457(b) plan. It’s mostly up to the employees to make sure they’re saving an adequate amount.
- 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.
The 403(b) Plan
A 403(b) plan is typically offered to employees of private nonprofits 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.
When these plans were created in 1958, they could only invest in annuity contracts. So, they were known as tax-sheltered annuity (TSA) plans or tax-deferred annuity (TDA) plans.
These plans are most commonly used by educational institutions. However, any entity that qualifies under IRS Section 501(c)(3) can adopt it.
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.
The annual contribution limit, which is also called the elective deferral, is $19,000 for 2019. In 2020, the threshold rises to $19,500. For 2019, an additional catch-up contribution of $6,000 is allowed for workers age 50 and above. The catch-up contribution limit increases to $6,500 in 2020.
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 are eligible for this provision, which allows for an extra $3,000 payment a year. However, this provision also has a lifetime employer-by-employer limit of $15,000. 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 $56,000 for 2019 or $57,000 for 2020. 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 them in a specific order. First, they apply the elective deferral. The IRS then uses the 15-year service catch-up provision. Third, they apply the age 50 catch-up contribution. It is an employer's responsibility to limit contributions to the correct amounts.
The rules for rolling over 403(b) plan balances have been loosened considerably over the past few years. Employees who leave their employers can now take their plans with them to another employer. They can roll their plans over into another 403(b), a 401(k), or another qualified plan. They can also choose to roll their plans over into a self-directed IRA instead.
Employees can now 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 59½, no matter if you’re still working at that organization or not.
- Distributions taken before age 59½ are subject to a 10% early-withdrawal penalty unless a special exception applies.
- All normal distributions are taxed as ordinary income.
- Roth distributions are tax-free. However, 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.
- Required minimum distributions (RMDs) must begin at age 72. The age for RMDs was 70½ until it was raised by the SECURE Act of 2019. Investors can avoid RMDs if they roll the plan into a Roth IRA or other Roth retirement plan. Failure to take a required 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 mostly the same as for 401(k) plans. Participants cannot access more than the lesser of $50,000 or half of their plan balance. Furthermore, 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. However, the Employee Retirement Income Security Act (ERISA) permits these plans to invest directly in mutual funds. This situation is a source of ongoing debate in the financial and retirement planning community. 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.
Importantly, 403(b) plans differ from their 401(k) counterparts in that they have no vesting provisions. However, they now provide the same level of protection from creditors as qualified plans.
Plan participants should also be aware of all of the fees charged by their plan and investment providers. The plan administrator must provide a complete breakdown of these fees to all plan participants.
How to Choose
If you need more time to put aside money for retirement, a 457 plan is best for you. It has a better catch-up policy and will allow you to stash away more money for retirement.
A 403(b) is likely to be your best bet if you want a larger array of investment options. “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 also a third option: If you are eligible for both plans, you can split your contributions between them.
That means you can put away $38,000 in 2019 or $39,000 in 2020, not including any catch-up contributions if you’re eligible. “This is especially appealing to employees who have a great income and are trying to minimize their taxes,” notes Chira.