The 457b is really just the slightly different sibling of the 401k. It is a tax-advantaged retirement account that is used by employees of local and state governments to save for retirement. There are also some tax-exempt organizations that also are permitted to utilize 457b plans.
As a similar benefit, federal government employees have access to a Thrift Savings Plan (TSP) rather than a 457b. The 457b is also commonly referred to as a deferred compensation plan or deferred comp plan.
So how does this plan work, and what are the advantages and disadvantages of contributing to this type of plan?
The 457b plan does offer several benefits to government workers, such as tax-deferred growth of their savings, but these plans do come with a few drawbacks. Keep reading to see precisely how this plan works and what to be aware of as you plan for your retirement.
What Is The Purpose Of The 457b And How Does It Work?
A 457b plan works very similarly to a 401k. You can think of the 457b plan like the 401k for public employees such as police officers, firefighters, corrections officers, and some other municipal, county, state, and university workers. The main advantage of this plan is that it is offered through an employer and allows you to make pre-tax contributions into the plan, which then grow tax-deferred.
The real purpose of the 457b plan is to allow public employees a tax-advantaged way to save for retirement and supplement their pensions. Most government workers also are members of a local or state pension system. These pension systems are typically defined benefit plans. This means that the employee will receive a set benefit for life once they meet the criteria for retirement (usually based on age and/or years of service).
Typically, a pension provides a percentage of an employee’s working salary. This generally falls in the range of 50%-70%, depending upon the pension system. The purpose of the 457b plan is to supplement these pensions payments and provide more income in retirement to fill the “income gap.”
To read more on this, check out my article: Why Your Pension May Not Be Enough.
Understanding 457b Contributions
You are permitted to contribute a specific amount per year, which is set annually by the IRS. In 2020, you can contribute up to $19,500, and if you are older than 50, you may contribute up to $26,000. This is called the “catch up” provision.
Since the contributions into a 457b are pre-tax, you will pay ordinary income tax on the withdrawals in retirement. These withdrawals will be taxed at your future tax bracket rates when the withdrawal is made.
The 457b plan also has a Roth version. However, not every public employer offers this option. In a Roth 457b plan, your contributions would be made with after-tax dollars. The advantage to this option is that your contributions grow tax-deferred. However, when you withdraw money from the Roth 457b, the withdrawals are also tax-free.
With the Roth option, you will not get the tax deduction in the year you contribute; you reap the benefits later on!
Therefore, the significant difference between the 457b and the Roth 457b is how and when you will be taxed on your contributions and growth. The 457b plan allows you to contribute pre-tax today and reduce your tax burden in the present. At retirement, you will pay income tax on the full account value (contributions and growth).
Think of the regular 457b plan as “tax me later.” Contrarily, with a Roth 457b, you will pay tax on the contributions now but enjoy tax-free withdrawals later. Think of the Roth 457b as “tax me now.” The question becomes, do you think taxes will go up, go down, or stay the same in the future? Additionally, your employer may not offer the Roth option with their 457b plan, so that may make your decision very easy.
Is There An Employer Match?
Public government employers very rarely provide a match to their employees’ contributions within a 457b plan. This is partially due to the fact that they are already contributing to the pension system in which that employee is a member.
If you are lucky enough to have an employer that makes match contributions, the contributions do, in fact, count towards the annual contribution limit, which is currently $19,500. This is where the 457b plan differs from a 401k or 403b.
For example, if your public employer matches/contributes $1,500 in 2020, you as the employee may only contribute $18,000 for the year. An employer could make the entire $19,500 contribution if they wanted to. However, I have never personally seen that; and I would venture to say that will probably never happen for the average public employee.
The Drawbacks To The 457b
As we said, most government employees are members of a pension system. Therefore, a 457b plan is considered a supplemental retirement savings plan for them. That is why an employer match is uncommon. Whereas, many private-sector workers rely on only a 401k and do not belong to a pension system.
In turn, many private-sector employees do receive an employer match. It is essential to understand the difference between a defined benefit plan such as a pension and a defined contribution plan like the 457b and 401k.
The difference boils down to this: the burden of providing income with a pension falls on the back of the pension system. You make your contributions, and they are responsible for investing that money and then pay you a set benefit for life regardless of what the economy or stock market is doing.
With the 457b or 401k, YOU, the employee, are responsible for providing income from that account. Things such as market volatility or a bad economy can impact your account balance and future income from that account.
It is important to remember that for public employees, the 457b is a supplement; an added benefit. This plan will not be a significant retirement benefit that will draw people to a government job. Typically, the draw is the pension as pension plans are extremely rare in the private sector today.
457b Limitations
One of the issues nationwide with 457b plans is the lack of education and lack of choices. What I mean by that is to contribute to a 457b plan, it must be approved by your employer through what is commonly referred to as a “payroll slot.” This means that your employer approves different companies or vendors to offer this type of plan to their employees, allowing them to make contributions through paycheck withholdings.
For example, an employee can agree to have $100 per paycheck taken out and sent to the company holding their 457b account. You cannot go out an open a 457b plan that is not approved by your employer.
The problem is that the 457b is not an investment per se, but a tax code. There are thousands of different investments you can hold within your 457b account, and hundreds of companies offer it. In a 457b plan, the employer may only have one or two companies approved to offer 457b’s to their employees – with limited investment options.
Frankly, what this means is that your employer could have some great options, some terrible options, or a mix. So how do you choose? By educating yourself and asking the right questions.
Lack Of Education
This brings us to our other issue – lack of education. Rarely do employers offer any training on the 457b plan or how to choose one that is right for you and your financial goals.
Typically, what they will do is allow representatives from their approved 457b companies to attend new employee orientations, union meetings, or hang out on-site to try and enroll employees into their company’s plan. The problem with this is that employees are usually getting a sales pitch from competing representatives and not true financial education or beneficial financial advice.
This is because these representatives earn a commission for new enrollments. You need to be working with an independent financial advisor to ensure you are actually enrolling in the most beneficial plan possible and not being “sold” a plan by the first representative that you meet.
Learn more about this in my article: Is Your “Financial Advisor” Actually an Advisor?
Aside from the lack of proper education and guidance, unnecessarily bringing in multiple companies and representatives can also unnecessarily increase the plan fees for the 457b participants. Ideally, you would like to see your employer approve one or two quality companies with a broad range of excellent investment options.
Some other factors that come into play with the fees include the investment offerings within the plan and the size of the plan. More extensive plans typically offer lower fees, and the 457b companies have more margin to operate with. This can also largely depend upon the company and how friendly they are to public employees.
I have seen 457b plans that charge their participants no annual fee up to fees that are as high as 5% annually. Don’t be fooled; these annual fees will add up to a large sum of money throughout a 20- or 30-year career!
Hardship Withdrawals
When it comes to withdrawals from your 457b, there are pros and cons. Hardship withdrawals taken from a 457b can be a bit tricky. Typically, these will only work for an “unforeseeable emergency” when no other resources or options are available. Then, if an early withdrawal is taken, there is usually a certain waiting period for new contributions or deferrals.
Early Distributions And Taxes
There is one massive perk with a 457b when it comes to distributions. The pro? The 59 ½ rule does not apply here!
With other qualified plans like a 401k or an IRA, the account owner must be 59 ½ to withdraw funds without a 10% IRS penalty (yes, there are a few exceptions there). However, in a 457b plan, the account holder must ONLY be separated from employment to withdraw these funds without a 10% tax penalty.
Do not confuse the early withdrawal penalty with income tax. You will still be responsible for income tax on the withdrawals. However, if you retire or separate from your employer, you can take money from your account without a 10% penalty – even if you are younger than 59 ½.
This means that if you retire early, retire with a disability, or make a career change, you can withdraw funds without a penalty. If you switch employers, you can transfer your old 457b to a new one with your new employer without a penalty. You can also transfer a 457b to an IRA or 401k.
Word of caution: early distributions are great for flexibility. However, for some, this could be a problem. Early distributions become a problem if this money is prematurely withdrawn when it could have grown over time and benefited the retiree later in life.
It is always important to consider your entire financial picture and always have multiple sources of retirement income. Just because you have early access to funds does not always mean it is best to do so.
Takeaways
The 457b plan is a unique supplemental retirement plan that is exclusively available to government and other specified employees. There are some unique advantages to deferred compensations plan that uniquely benefit the employee.
However, it is vitally important to understand how your employer’s plan(s) works, the provisions, and fees of your employer’s plan(s). Structuring a plan that is tailored to your overall retirement portfolio is just as important as the benefits it provides.
Ideally, you would also want a trusted advisor on your side to help you navigate the options and make the best choice. You can also learn some common pitfalls and mistakes to avoid with your 457b here: Don’t Make These 457b Mistakes (Deferred Comp Plan).
If you have questions or would like personalized advice in building your financial house, you can schedule a one-on-one call with Gary (who is an investment advisor/fiduciary) here: https://calendly.com/downes-dalessio/thin-line-financial
