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By Dr. James M. Dahle, WCI Founder
Section 457 of the Internal Revenue Code (IRC) is all about deferred compensation plans for state and local governments and tax-exempt organizations. The most common type of plan seen under this section is a 457(b) plan. The key point to understand about 457(b) plans is that they are deferred compensation from your employer to you. That means that it is money the employer owes you but that the employer has not yet paid you.
Why in the world would anyone be willing to let employers keep the money they owe to the employee? Well, there are two very big reasons:
- Tax Benefits
- Asset Protection
In the first case, a 457(b) functions as another retirement plan, shielding your investments from any tax drag as they grow. There are both tax-deferred (traditional) and tax-free (Roth) versions. In the second case, the 457(b) shields your assets from your creditors. It isn't your money (yet), so your creditors can't take it. Of course, it may be available to your employer's creditors. More details about that below.
Here's what you need to know about 457 retirement plans.
What Is a 457 Deferred Compensation Plan?
A 457 plan simply refers to any plan that operates under section 457 of the IRC. Subsection (a) of the code really defines all 457 plans when it says that this plan is only taxable to the participant in the year the money is paid to the participant, i.e. it is deferred compensation. Subsection (b) gives further details for the plans we're really discussing in this post. Interestingly, subsection (f) is also relevant.
What Is a 457(f) Plan?
A 457(f) plan is a non-qualified deferred compensation plan where all contributions are made by the employer and none by the employee. It is usually just for a select management group or highly compensated employees, and it involves money that is paid to the employee at the time of retirement. It is sometimes called a Supplemental Executive Retirement Plan (SERP). With a 457(f) plan, the benefits are taxed when they vest, NOT when they are paid out. This makes it an “ineligible” 457 plan. 457(f) plans may have higher contributions than a 457(b) plan. In the remainder of this post, we will not be discussing 457(f) plans, only 457(b) plans.
What Is a 457(b) Plan?
The more commonly used 457 plan is the 457(b) or 457B. These plans are eligible (meaning no taxes due until the money is actually paid out), non-qualified (by the IRS, meaning the employee doesn't own the assets) retirement plans. They are typically offered by government employers or nonprofits, often in conjunction with a 403(b) and/or a 401(a) plan.
Governmental vs. Non-Governmental 457(b)s
The most important thing to know about your 457(b) plan is whether it is a “governmental” plan or a “non-governmental” plan. In this particular case, a governmental plan is better in all respects than a non-governmental plan.
Your asset protection and, probably more importantly, your distribution options are significantly better with a governmental 457(b). A governmental 457(b) can just be rolled over into a 401(k) or IRA when you leave the employer. That makes using a governmental 457(b) a “no-brainer” most of the time.
How Does a 457 Plan Work?
For the most part, a 457(b) plan works just like your 401(k) or 403(b). It's an “extra” retirement account. You put money in and then select which investments in the plan to invest the money into. Once you finish working, you take the money out and use it for your expenses.
How Much Can I Put in My 457 Plan?
The annual contribution limit for a 457(b) plan mirrors that of a 401(k) or 403(b)—$20,500 in 2022. However, the catch-up contributions work differently. Read your plan document carefully to understand if your plan allows catch-up contributions at all and, if so, how they work. The IRS allows a governmental 457(b) plan to do the same 50-year-old-plus extra $6,500 catch-up contributions that 401(k)s and 403(b)s allow.
However, they also allow both governmental and non-governmental 457(b) plans to have “special catch-up contributions” in the last three years before retirement age where you can either double your contributions ($41,000 per year in 2022) or make up for any years that you didn't put in the maximum $20,500 . Unfortunately, it's whichever of those two is less. So, total catch-up contributions are never going to be more than $20,500 x 3 = $61,500 . If your plan offers both the 50+ catch-up and a type of special catch-up, you can only do the one that allows the larger contribution, not both. So if your plan's retirement age is 65, you can do $6,500  extra from 50 to 62 and then possibly $20,500  extra from 63 to 65. I know, it's complicated. I don't write the rules, I just tell you what they are.
When Can You Withdraw from a 457 Plan Without Penalty?
There is no early withdrawal penalty from a 457(b), at least if you are allowed to make a withdrawal. While taxes may be due, there is no extra 10% tax for withdrawing prior to age 59 1/2. This can be both an advantage and a disadvantage.
However, plans generally require you to either separate from the employer first or, at least, have a hardship before you can make a withdrawal. This is beneficial in that you can tap your 457(b) first as an early retiree, leaving your 401(k) or 403(b) to cover spending after you are 59 1/2. This is usually a good idea anyway with a non-governmental 457(b), given the asset protection concerns. The disadvantage comes in with some non-governmental plans that have relatively poor distribution options, such as requiring you to withdraw the entire 457(b) balance in the year you leave the employer. This can result in withdrawals being taxed at the same or even higher tax rate than you had at the time of contribution!
Do 457 Plans Have Required Minimum Distributions?
Like 403(b)s, 401(k)s, Roth 401(k)s, Roth 403(b)s, and traditional IRAs, 457 plans have required minimum distributions (RMDs). If you have not already depleted the account, beginning at age 72, you will be required to take a certain amount of money out of your account each year or pay a massive tax (50% of the amount you should have withdrawn). You don't have to spend the money, but you do have to remove it from the retirement account and reinvest it elsewhere.
How Are 457 Distributions Taxed?
The taxation of a 457 plan is identical to that of a 401(k) or 403(b). If you made tax-deferred (traditional) contributions, you get an upfront tax break at your marginal tax rate. The investments then grow in a tax-protected way without the tax drag you would see in a taxable account. At the time of withdrawal, all money taken out is taxed at ordinary income tax rates. However, if you have minimal other taxable income, you can use the 457(b) withdrawals to “fill the brackets,” resulting in a much lower effective tax rate on withdrawals than you saved at the time of contribution. This arbitrage of tax rates is a major benefit of using retirement accounts to save for retirement.
Are There Roth 457s?
Some 457(b) plans allow Roth contributions. These work precisely the same way as in a 401(k) or 403(b). While you do not get an upfront tax deduction, the investments grow tax-free and will be completely tax-free at the time of withdrawal. If you roll the money into a Roth IRA eventually, you can even avoid having to take RMDs.
Can I Withdraw from My 457 While Still Employed?
While every plan may be different, 457(b) plans generally do not permit in-service withdrawals except in the case of hardship. The IRS has this to say about what qualifies as a hardship and what does not:
“Under a 457(b) plan, a hardship distribution can only occur when the participant is faced with an unforeseeable emergency. (Code Section 457(d)(1)(iii))
An unforeseeable emergency is a severe financial hardship resulting from an illness or accident, loss of property due to casualty, or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant or beneficiary. Examples of events that may be considered unforeseeable emergencies include imminent foreclosure on, or eviction from, the employee's home, medical expenses, and funeral expenses. Generally, the purchase of a home and the payment of college tuition are not unforeseeable emergencies.
(Reg. Section 1.457-6(c)(2)(i))
Whether a participant or beneficiary is faced with an unforeseeable emergency depends on the facts and circumstances. However, a distribution is not on account of an unforeseeable emergency to the extent that the emergency can be relieved through reimbursement or compensation from insurance, liquidation of the participant's assets, or cessation of deferrals under the plan. (Reg. Section 1.457-6(c)(2)(ii))
A distribution on account of an unforeseeable emergency must not exceed the amount reasonably necessary to satisfy the emergency need. (Reg. Section 1.457-6(c)(2)(iii))”
Severe financial hardship is the key. You'll need to convince your employer, but that shouldn't be too hard in a legitimate situation.
What to Do with Your 457 After Leaving a Job
What you do with your 457(b) after you quit, retire, or are fired depends heavily on whether it is a governmental or non-governmental 457(b). If it is a governmental plan, you have all kinds of options. You can
- Roll it into a traditional IRA (or Roth IRA if it is a Roth 457(b))
- Convert it to a Roth IRA
- Roll it into your new employer's 401(k) or 403(b)
- Roll it into an individual 401(k) if you qualify to have one
- Roll it into your new employer's governmental 457(b)
- Leave it in the 457(b) plan
- Pull it out gradually or all at once and pay taxes on it (no taxes due if a Roth 457(b))
If your 457(b) is a non-governmental plan, your options are far more limited but include:
- Roll it into your new employer's non-governmental 457(b) (if both plans permit rollovers)
- Leave it in the 457(b) plan
- Pull it out according to the options provided by the plan and pay any taxes due (no taxes due if a Roth 457(b))
Can You Roll Over a 457(b) to an IRA?
Yes, but only if it is a governmental 457(b) and you have separated from the employer.
Can You Contribute to a 457 After Retirement?
No. Only income earned from that employer can go into a 457(b). Once you have left the employer, no additional contributions can be made.
Benefits of a 457 Plan
#1 Additional Savings
The main benefit of using a 457(b) plan is you basically get another retirement plan similar to your 403(b). You can double your tax deduction and double your savings.
#2 No Early Withdrawal Penalty
457(b) plans are not subject to the Age 59 1/2 rule, meaning you can access the money without penalty as soon as you leave the employer. They're a great option to spend during early retirement. You just withdraw from the 457(b) first and leave your other retirement accounts until your 60s and later.
#3 Asset Protection
Like most retirement plans, 457(b) plans are good asset protection vehicles since they are generally protected from YOUR creditors. Governmental 457(b) plans are held in trust. Non-governmental 457(b) plans are subject to the creditors of your employer.
Downsides of a 457(b) Plan
It's not all rainbows and unicorns. These plans have downsides, too.
#1 Limited Investment Options
Like with most employer-provided retirement accounts, the employer gets to choose the investments. They might not have done a very good job. While you can remind them of their fiduciary duty to their employees, employees are rarely able to change the options. Alternative investments (precious metals, private businesses, real estate, cryptocurrency) that you might be able to invest in with a self-directed 401(k) or self-directed IRA are also generally not an option.
It costs something to run the plan, and that cost is often passed along to the employees. Read your plan document and understand what fees you will be responsible for.
#3 Withdrawal Restrictions
This is retirement money, and in order to get the tax benefits the government is offering you to save for retirement, you must put up with some restrictions on accessing your money. You generally can't get it before you leave the employer. If you roll the money into an IRA, 401(k), or 403(b) after separation, the Age 59 1/2 rule will apply. Non-governmental 457(b) plans are also notorious for providing limited withdrawal options. Make sure you understand what they are and find them acceptable before investing.
#4 Asset Protection Concerns
With a non-governmental plan, the 457(b) money still belongs to the employer and is subject to their creditors. If they go bankrupt, you could lose your money.
Should You Use Your 457 Account?
Naturally, once an investor understands the downsides of a 457(b) account, they are often hesitant to use it. Here is how to decide.
457 Tax Savings vs. Risk of Loss
You are really weighing the tax savings of using the account against the restricted investments, limited withdrawal options, and, especially, the risk of loss. However, most doctors with access to a governmental 457(b) should consider it just another retirement account like their 403(b). In fact, some people aiming for early retirement actually fund it in preference to a 401(k) or 403(b). If the fees and investments are absolutely horrendous, you might want to give it a second thought, but even then, it often makes sense to use the plan, as you can probably roll it into a good 401(k) or IRA in just a few years when you separate from the employer. That still leaves you decades to enjoy the additional tax and asset protection benefits of retirement account investing.
However, if you have a non-governmental plan, you'll need to spend a little more time on your decision. If the fees and investments stink, you might be stuck with them for a much longer period of time. The withdrawal options might also be terrible. I have seen plans that require you to withdraw the entire amount as soon as you leave the employer. That could result in a “reverse tax arbitrage,” where you actually pay a higher tax rate on withdrawals than you saved on contributions. It is not uncommon to have to withdraw the money over just five or 10 years after separating, whether you are retired or not.
More importantly, you have to look at the employer. If your hospital is on shaky financial ground, you might want to limit how much of your compensation you want to defer. A bird in the hand may beat two in the bush. Some doctors avoid maxing out their 457(b), stop contributing after a few years, or avoid using it altogether due to this concern. While the tax savings are nice, the return of principal matters more than the return on principal. Talking to the hospital CFO about future expectations might help you decide whether to use the 457(b).
Personally, I think the risk of loss due to your employer going bankrupt is pretty low. While I'm sure 457 dollars have been lost, I've never run into a doc that had it happen to them. It certainly isn't common. I don't think I'd be willing to give up a $5,000-$6,000 per year tax break (along with ongoing tax and asset protection) because of that worry. I'm much more worried about market risk than 457 risk. So, I'd go ahead and use the plan. But I'd be sure to max out my 401(k) and Backdoor Roth IRAs first. And I'd definitely spend that money first in retirement.
What Is the Difference Between a 403(b) and a 457(b)?
Many times, 457(b) plans are described online or by the HR representatives as another 403(b) account only available to the high-earning employees of the organization, like the physicians. In many regards, the 457(b) is quite similar to your available 403(b):
- Both have annual maximum savings of $20,500  per year
- Both are contributed to with pre-tax dollars providing a nice tax break
- Both can have a tax-free (Roth) option
- Both grow in a tax-deferred (or tax-free if Roth) manner
- Both are taxed as ordinary income upon distribution
- Oftentimes, the same investment options will be available in both
- Both require withdrawals to start at age 72 with required minimum distributions
In one important way, the 457(b) is even better than the 403(b). It has no penalty for withdrawing money prior to age 59 1/2. The lack of the 10% early withdrawal penalty makes it an excellent source of income for a physician planning an early retirement. However, a 403(b) is always your money and always has a plethora of distribution options. That is not the case for a non-governmental 457(b).
At the end of the day, a 457(b) is a wonderful option to enjoy some additional tax and asset protection. Learn about your account and use it. Just be aware of the potential downsides, particularly of a non-governmental 457(b).
What do you think? Do you have access to a 457(b)? Do you use it? Why or why not?