What is the difference between a 401(k) plan and a 457 plan?
401(k) plans are IRS-sanctioned, tax-advantaged employee retirement savings plans offered by private, for-profit employers and some nonprofit employers. They are the most common type of defined-contribution retirement plans.
457 plans are IRS-sanctioned, tax-advantaged employee retirement plans offered by state and local public employers and some nonprofit employers. They are one of the least common forms of defined-contribution retirement plans.
Differences Between 401(k) and 457 Plans
401(k) plans are considered qualified retirement plans and are therefore subject to the Employee Retirement Income Security Act of 1974 (ERISA). 457 plans, however, are a type of tax-advantaged non-qualified retirement plan and are not governed by ERISA.
Since ERISA rules do not apply to 457 accounts, the IRS does not assess a "premature withdrawal" penalty to 457 participants who take withdrawals before age 59.5. The withdrawals are still subject to normal income taxes. Premature withdrawals from a 401(k) result in an additional 10% tax penalty.
457 plans feature a "Double Limit Catch-up" provision that 401(k) plans do not. This provision is designed to allow participants who are nearing retirement to compensate for years in which they did not contribute to the plan but were eligible to do so. Thus, under the right conditions, a 457 plan participant may be able to contribute as much as $35,000 to his plan in one year.
While both plans allow for early withdrawals, the qualifying circumstances for early withdrawal eligibility are different. Plan participants can make early withdrawals from a 401(k) under "financial hardships," which are defined by each 401(k) plan. With 457 accounts, hardship distributions are allowed after an "unforeseeable emergency," which must be specifically laid out in the plan's language.
Both public government 457 plans and nonprofit 457 plans allow independent contractors to participate. Independent contractors are not eligible to participate in 401(k) plans.
Similarities Between 401(k) and 457 Plans
As defined-contribution plans, both 401(k) and 457 plans are funded when employees contribute through payroll deductions. Participants of each plan set aside a percentage of their salary to put into their retirement account. These funds pass to the retirement account without being taxed, unless the participant opens a Roth account, and any subsequent growth in the accounts is not taxed.
As of 2018, both 401(k) and 457 plans have an annual maximum contribution limit of $18,500. For employees over the age of 50, both plans contain a "catch-up" provision that allows up to $6,000 in additional contributions. Contributions to each plan qualify the employee for a saver's tax credit. It is possible to take loans from both 401(k) and 457 plans.
Since 457 plans are nonqualified retirement plans, it is possible to contribute to both a 401(k) and 457 plan at the same time. Many large government employers offer both plans. In such cases, the joint participant is able to contribute maximum amounts to both.
401(k) plans are tax-deferred retirement savings accounts offered by private (non-government), for-profit employers, while 457 plans are offered only to public employees (working for schools, charities, colleges/universities, and state & local governments), and other tax-exempt entities under 501(c)(3) of the Internal Revenue Code.
Similar to 401(k) plans, 457 plans provide a way for employees to save money for retirement by deducting from pre-tax income employee contributions to the plan, which are then invested and taxed only upon withdrawal in retirement, at which point the retiree's ordinary income tax rate is applied. Since we have no active earnings in retirement (though we may have some passive income from investments or annuities and the like), our ordinary income tax rate is generally very low post-retirement and much higher while we're still part of the workforce. Accordingly, the tax deferral associated with 401(k)s and 457 plans can provide meaningful tax savings.
With a 457 plan, employees make pre-tax contributions in the form of payroll deductions, and that money grows tax-deferred until retirement. Many public and non-profit employers offer both a 457 and 403(b) plan, as well as a separate, primary retirement plan - often a Defined Benefit pension. With Defined Benefit pension plans, the employer contributes to the plan, and the plan is required to pay pre-specified installments ("defined benefits") to employees in retirement, versus Defined Contribution plans (such as 401(k)s, 457 and 403(b) plans) under which employers agree to make matching contributions but have no liability for ultimate payments or cash available upon retirement. 457 plans allow for double deferral when coupled with a 403(b), as employees can legally contribute twice the annual contribution limit by combining the two. For example, an employee can reach the contribution limit for a 403(b) plan, which in 2016 is $18,000 (and also represents the maximum allowable contribution from pre-tax income to 401(k) accounts), and still contribute the entire contribution limit to a separate 457 plan (or another $18,000 in 2016, for $36,000 in total pre-tax contributions). 401(k) plans do not offer any double deferral opportunities, and contributions are capped out at the annual limit of $18K. As previously noted, many public employees with access to 403(b) and 457 plans also have a defined benefit pension plan from which they will receive retirement income. In this manner, employees who can afford to make large pre-tax contributions (up to the maximum, double-deferral) could choose to accumulate far more employer-sponsored retirement income than most employed by corporations (or others working in the for-profit sector).
As with all Defined Contribution plans, growth is tax deferred. Upon taking approved distributions, people pay ordinary income tax on approved 457 distributions. The key difference between 403(b) or 401(k) and 457 plans involves the distribution rules. 457 plans allow individuals to withdraw funds early without having to pay the 10% early withdrawal penalty imposed on 401(k) or 403(b) holders, but only in the event that they switch employers. The drawback with a 457 plan is its strict age-related distribution limitations. Anyone still working for the sponsor of the 457 plan may not withdraw funds without penalty until age 70.5. If they wish to withdraw funds before then, they must either switch employers or be penalized for early distribution. In contrast, individuals can take 401(k) distributions without penalty any time after they've reached the age 59.5. The incremental 20 years employees must wait before making eligible withdrawals free of penalty under a 457 plan can be onerous.
Where applicable, anyone can contribute to a 403(b) plan, a 457 plan, both plans, or neither. Generally speaking, its more common for younger employees to make 457 plans their primary plan because they can take distributions at any age when they stop working for the sponsor-employer. On the other hand, those approaching the retirement age may not want to switch jobs or commit to a plan that would require they do so to avoid penalties, fearing a lower salary elsewhere. As a result, older employees generally make 403(b) plans their primary, and use 457 plans as a supplement in the event they wish to contribute more than the annual contribution limit.
Not a whole lot. Both are "Qualified plans" under the IRS tax code and they "qualify" for preferential tax treatment, namely tax-deferred growth. Both are offered by employers, and typically they have a matching contribution amount. Most 457 plans are for public employees, like teachers, fire fighters, etc. 401(k) plans typically come from private employers, like IBM 401(k) plan versus the Utah State Teachers 457 plan.
For the individual employee a 401k and 457 plan are basically the same. Just depends on which one your employer offers and the investment choices within each plan.
For more specifics on the various retirement accounts out there you might like this post:
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DAVID RAE, CFP®, AIF® is a Los Angeles-based financial planning specialist with DRM Wealth Management, a regular contributor to Advocate Magazine, Huffington Post, Investopedia not to mention numerous TV appearances. He helps smart people across the USA get on track for their financial goals. For more information visit his website at www.davidraefp.com