By Tina Wood-Wentz, MS, Guest Writer
The White Coat Investor and his guests and network members have previously covered many important aspects of both governmental and non-governmental 457(b)s. But there are some additional practical usage considerations for non-governmental 457(b)s.
As you are considering whether or not to use a non-governmental 457(b), start by remembering the importance of looking at the financial health of your institution since it’s not your money yet, assessing the value given the lack of a Roth option, and making sure you are OK with the distribution options.
Only after you’ve already made the decision that contributing to a non-governmental 457(b) is right for you should you move on to consider three additional implementation issues.
First, some background on timing and the official process. In order to be eligible for a top-hat, non-governmental 457(b), the preceding year you have to have earned above the highly-compensated employee threshold. Then after you have earned eligibility, you have to wait for access. Often that’s open enrollment in May and June. You may be allowed to elect a different contribution percentage during two contribution periods: July-December of the current year and January-June of the following year. You likely can’t make changes on these elections until next year’s open enrollment, whether you’d prefer to increase or decrease those elections. On separation of service, you will be required to elect a distribution plan; a common set of options would be to allow you to choose the date payout will begin, along with a payout period of 0, 5, 10, or 15 years.
#1 Timing Eligibility for Non-Governmental 457(b) Contributions
Your job situation may well change many times throughout your career. As you go from a training salary to your full professional salary—or any time you change employers—if you can negotiate that professional salary to be high enough to cross the highly-compensated employee threshold in what remains of the year, you will minimize your time waiting for access to your non-governmental 457(b). To put numbers to that, at the currently highly compensated employee threshold of $130,000 per year, if you earn a $260,000 per year salary at your new job, that means you need to have changed companies no later than halfway through the calendar year to be eligible for the following year’s contributions at your new employer. If you earn a $500,000 per year salary at your new job, you need to have changed jobs with slightly over one-quarter of the year remaining to meet that threshold.
Another potential loss point centers around cash flow. Many physicians delay contributing to their 457(b) until later in the year, after they’ve already reached the Social Security wage base ($142,800 in 2021 and $147,000 in 2022) and no longer are subject to the 6.2% Social Security employee withholding. Combining this delay strategy with unexpected changes—such as family or medical leave with reduced compensation, a salary cut or job loss due to institutional financial hardship, or an unplanned job change—can leave you vulnerable for incomplete or not at all filling your planned 457(b) annual contribution.
#2 Maximize Getting the Money in 457(b) Account Consistently
Contribution limits for 457(b)'s are announced by the IRS in late October or in November for the following calendar year. With 457(b) open enrollment in May and June for July-December and January-June, if you don’t elect a high enough percentage in the second window, you may get caught out on threshold step-ups for contribution limits. For example, if you elected in June of 2021 that you wanted a small enough percentage to only just contribute $19,500 in January-June 2022, you would be under-contributing now that the 2022 contribution limits will jump from $19,500 to $20,500 in 2022. If your situation permits, you may be able to elect in May/June 2022 to finish filling the 2022 bucket in July-December 2022, but that plan does leave more room for chance problems. Now, these bump-ups in contribution limits are usually in $500 increments, and the last double-jump happened in 2009, so they aren’t the most common in recent history. Since the 2009 double jump, about half of the years have been no increase years, and half have been single-step increase years. Compared to the other two points we’re covering today, this one is less important.
#3 Be Aware of State Taxation of Your 457(b) When Getting the Money Out
Traditional (pre-tax) retirement account plans are often utilized by physicians and other high-income earners in order to avoid paying taxes during the earning years, in the highest marginal brackets. A common retirement strategy is to relocate to a no income tax state to also avoid paying state income tax on the withdrawals. However, a “gotcha” relevant to this discussion is for nonqualified plans where payments are made in less than 10 annual payments. If your 457(b) funds were earned when you were working in a state that pursues taxation on these nonqualified deferred compensation plans, choosing a lump sum or five-year payout could cause you to be subject to state taxation in your earning state, even if you are a nonresident at the time of payout. You can avoid this problem no matter your state of earning and only be subject to the relevant income tax of your state of residence if you elect a 10- or 15-year payout.
Examples of Utilizing a 457(b) Non-Governmental Account
Let’s make this concrete with two examples, one that went well and one that was not optimized. Note that future numbers are hypothetical.
We have Happy Hannah, who did everything right. And we have Sad Stan. Stan didn’t know about the power of planning ahead regarding 457(b) eligibility, contribution access timing, threshold steps, or about state taxation of income from non-qualified plans paid to nonresidents. They both worked at the same hospitals in their early careers, at hospitals with 0-, 5-, 10-, and 15-year payout options, in a state that pursued non-resident taxation of non-qualified plans paying out in under 10 years.
Happy Hannah did her residency at nonprofit academic medical center A and applies to other nonprofit hospitals for her post-residency career in 2020. She keeps in mind her goal of having a salary over $130,000 in the shortened window of her remaining 2020 employment, and she negotiates a salary and start date that combine to give her over $125,000 in income at her new job at Hospital B for the rest of 2020. In May 2021, Hannah receives open enrollment paperwork for her employer’s non-governmental 457(b), and she elects a high enough percentage for the July-December 2021 window to max out her $19,500 contributions. She also elects a high enough percentage for the January-June 2022 window to max out her $20,500 contribution in 2022, even though she didn’t know at election time that there would be a contribution limit boost, let alone that it would be larger than typical. As she approaches her two-year service anniversary, her family needs to move, and so she interviews and accepts a job with another nonprofit Hospital C. Continuing to have kept her 457(b) access in mind, she coordinates her salary and start date to make sure she has at least $135,000 in income at Hospital C in 2022, giving her the ability to contribute to Hospital C’s 457(b) in July 2023, and she earns more than $140,000 in 2023 for continued contribution access to Hospital C’s 457(b) for 2024.
(Additionally, Hannah chooses to live these first few years like a resident—she stacks this 457(b) contribution with traditional 403(b) contributions, giving her tax-advantaged retirement plans a boost early in her career, while simultaneously reducing her apparent income for her student loan income-driven repayment plan.)
Come retirement, Hannah moves to a state with no state income tax. She withdraws her 457(b)s over the course of 15 years, avoiding the nonqualified plan payout income tax trap of her employment state.
Compare this to the situation of Sad Stan. Stan also completed his residency in June 2020. He started work at nonprofit Hospital B a month after Hannah, and his 2020 income at Hospital B did not cross the $130,000 threshold. He earns more than $130,000 in 2021 at Hospital B, and in May 2022, he elects to begin contributing to his 457 in the second contribution window (January-June 2023) in order to get his cash flow in hand. But before the end of 2022, like Hannah, his family moves and he is hired at nonprofit Hospital C. Stan earns over $140,000 in 2023 at Hospital C and finally has the ability to contribute to Hospital C’s 457(b) as of July 2024. By the time of this first contribution for Stan, Hannah already has made three years of contributions. And when Stan reaches retirement, he also moves from an income tax state to a non-income tax state, but since he withdraws his 457(b) across only five years, he is subject to the nonqualified plan payout taxation and therefore still has to pay state income tax to his employment state.
You can maximize the value of your non-governmental 457(b) with a little planning ahead and attention to detail.
Do you have any other nuggets of wisdom when using 457(b) accounts? Comment below!
[Editor's Note: Tina Wood-Wentz is a Data Scientist and Financial Educator at Wood Financial Services LLC. This article was submitted and approved according to our Guest Post Policy. We have no financial relationship.]