What Is a 457 Plan?
Generally speaking, 457 plans are non-qualified, tax-advantaged, deferred compensation retirement plans offered by state governments, local governments, and some nonprofit employers. Eligible participants are able to make salary deferral contributions, depositing pre-tax money that is allowed to compound without being taxed until it is withdrawn.
- 457 plans are IRS-sanctioned, tax-advantaged employee retirement plans.
- They are offered by state, local government, and some nonprofit employers.
- Participants are allowed to contribute up to 100% of their salary, provided it does not exceed the applicable dollar limit for the year.
- Any interest and earnings generated from the plan do not get taxed until the funds are withdrawn.
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How a 457 Plan Works
Notably, 457 plans are similar in nature to 401(k) plans, only rather than being offered to employees at for-profit companies, they cater to state and local public workers, together with highly paid executives at certain nonprofit organizations, such as charities.
Participants of these defined contribution plans set aside a percentage of their salary for retirement. These funds are transferred to the retirement account, where they grow in value without being taxed. There are two types of 457 plans:
- 457(b): This is the most common 457 plan and is offered to state and local government employees.
- 457(f): A plan offered to highly compensated government and select non-government employees.
Employees are allowed to contribute up to 100% of their salary, provided it does not exceed the applicable dollar limit for the year. If the plan does not meet statutory requirements, the assets may be subject to different rules.
457(b) Plan Contributions
As of 2021, employees can contribute up to $19,500 per year. In some cases, workers are able to contribute even more.
For example, if an employer permits catch-up contributions, workers over the age of 50 may contribute an additional $6,500, making their maximum contribution limit $26,000 ($19,500 + $6,500).
Also, 457(b) plans feature a "double limit catch-up" provision. This 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. In this case, employees who are within three years of retirement age (as specified in their plan), may contribute $39,000, twice the annual contribution limit.
In certain circumstances, a 457 plan participant may be able to contribute as much as $39,000 to their plan in one year.
A lesser-known feature of the 457(b) plan is that the Internal Revenue Service (IRS) also special catch-up deferrals. The special pre-retirement catch-up deferral allows participants to make additional contributions for the three years prior to reaching normal retirement age. The special pre-retirement catch-up limit is double the normal limit, for a total of $39,000 in 2020 and 2021.
Dan Stewart, CFA®
Revere Asset Management, Dallas, TX
457 plans are taxed as income similar to a 401(k) or 403(b) when distributions are taken. The only difference is there are no withdraw penalties and that they are the only plans without early withdrawal penalties. But you also have the option of rolling the assets in an IRA rollover. This way, you can better control distributions and only take them when needed.
So if you take the entire amount as a lump sum, the entire amount is added to your income and may push you into a higher tax bracket.
With the rollover route, you could take out a little this year, and so on as needed, thus controlling your taxes better. And while it remains inside the IRA, it continues to grow tax-deferred and is protected from creditors.
Advantages of a 457(b) Plan
Contributions are taken from paychecks on a pre-tax basis, resulting in lower taxable income. For example, if Alex was earning $4,000 per month and contributing $700 to a 457(b) plan, Alex's taxable income for the month is $3,300.
Employees also have the option to invest their contributions in a selection of mutual funds. Importantly, any interest and earnings generated from these vehicles do not get taxed until the funds are withdrawn. Moreover, if an employee resigns, or retires early and needs to withdraw their funds, there is no 10% penalty fee, unlike 401(k), and 403(b) plans.
However, any early distribution from a 457 plan whereby the funds were a result of a direct transfer or rollover from a qualified retirement plan—such as a 401(k)—would be subject to the 10% penalty tax.
Limitations of a 457(b) Plan
Employer-matched contributions count toward the maximum contribution limit. For instance, if an employer contributes $10,000 to the plan, the employee can only add $9,000 until the $19,000 contribution limit is reached (unless they are permitted to use the catch-up option). In practice, most government employers do not offer contribution matching.