Both Roth IRAs and 457 plans are tax-advantaged ways to save for retirement, but they work differently. Anyone with earned income can open and contribute to a Roth IRA, provided they meet the income limits. By comparison, 457 plans are available only to employees of certain types of organizations. If you are eligible both for a Roth IRA and a 457 plan, here are some important things to consider.
- 457 plans are a type of retirement plan that some state, local government, and nonprofit employers provide for their workers.
- Roth IRAs are available to anyone who meets certain income requirements.
- You can contribute to both a 457 plan and a Roth IRA if you qualify.
What Is a 457 Plan?
A 457 plan is one of a number of retirement plans that employers can make available to their workers. Private, for-profit companies often sponsor 401(k) plans, while nonprofits, hospitals, and public school systems may use 403(b) plans.
Some state, local government, and nonprofit employers offer still another option: the 457 plan. At their core, all three of these plans have many of the same tax advantages.
How 457 Plans Work
With a 457—or a 457(b), as it is often called—your contributions are made with pre-tax dollars. So, you are not paying taxes on the money you put into the plan until you withdraw it later in life.
For 2020, you can contribute up to $19,500. If you are age 50 or older, you can make an additional $6,500 catch-up contribution. That increases your annual limit to $26,000, the same as with a 401(k).
But unlike a 401(k) or 403(b) plan, a 457 may allow you to make a special catch-up contribution for three years prior to your normal retirement age. If your plan permits, you can contribute the lesser of:
- Twice the annual limit, which equals $39,000 for 2020, or
- The basic annual limit plus the amount of the basic limit not used in prior years (this only applies if you are not using the regular age 50+ catch-up contributions).
For example, if your plan specifies 65 as your retirement age, you can contribute up to $39,000 per year once you are age 62, provided that it’s not more than your annual salary.
As with a 401(k), an employer can match your 457 contributions. If you invest $1,000 per month and your employer matches at 50%, you are getting $500 of free money every month.
Unlike 401(k) plans, 457 plans allow you to make larger catch-up contributions in the three years before you reach retirement age.
When Do You Pay Taxes?
While both 457 plans and Roth IRAs offer tax advantages, they are the exact opposite in terms of when you get your tax break. As mentioned, contributions to 457 plans are made with pre-tax dollars. You enjoy an upfront tax break since the contribution lowers your taxable income for the year. But you will pay taxes on any money you withdraw during retirement.
With a Roth IRA, you do not get an upfront tax break, but your contributions and earnings grow tax-free. You effectively pay your taxes when you make the contribution. As of 2020, you can contribute up to $6,000 per year to a Roth IRA, or $7,000 if you are age 50 or older, as long as you meet the IRS income limits. If you’re married and file taxes jointly, for example, you can make the full contribution if your modified adjusted gross income (MAGI) is less than $196,000.
Early Withdrawals From 457s and Roth IRAs
Unlike other employer-sponsored retirement plans, you can withdraw money from your 457 before age 59½ without penalty. But remember, you will still owe taxes on the withdrawal.
With a Roth IRA, your money comes out tax-free (and penalty-free) if your account is at least five years old, and you are age 59½ or older. You can withdraw your contributions at any time, for any reason, with no tax or penalty.
Do 457s and Roth IRAs Have Required Minimum Distributions?
Required minimum distributions (RMDs) apply to all employer-sponsored retirement plans, including 457s. Once you hit age 72, you have to start taking withdrawals or you risk having to pay a steep 50% tax penalty. (Note: The SECURE Act of 2019 increased the age to 72. But if you turned 70½, the old threshold, in 2019, you must start RMDs now.)
Roth IRAs, on the other hand, have no RMDs during your lifetime. That can make them a great way to transfer wealth to your beneficiaries, as long as you do not need the money for living expenses.
You Can Max Out Both a 457 and a Roth IRA
If you have a 457, you can max it out and still make a full contribution to a Roth IRA as long as you meet the income rules. Doing so can make financial sense if you have the money to spare.
In fact, having both types of retirement accounts can serve as a hedge against the unpredictability of future tax rates.
If tax rates are a lot higher when you retire, you will have significantly benefited from your Roth IRA because your withdrawals are tax-free. If tax rates are lower when you retire, your 457 will have been the more tax-efficient account. Either way, one will help to balance the other.
Putting a Roth Inside Your 457 Plan
What if you want the advantages of a Roth-type account inside your 457? Some employers offer a designated Roth option. If this is available, you can make after-tax contributions to your 457 plan that you can withdraw later, tax-free. Unlike a Roth IRA, however, your designated Roth account will be subject to required minimum distributions, so a separate Roth IRA could still be a better choice.