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.
Optimized Example
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.
Non-Optimized Example
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.]
I’m not sure it is a good idea for new attendings to use a NG-457. Think about this: about half of new attendings leave their new job, which will force distribution of the NG-457 (or you can keep it around like a wet smelly dog for 30 more years at your old employer). Income tends to go up in the first couple years after becoming an attending (maybe that is why you left the old job?). Taxes are scheduled to go up in 2026.
Thus, there is a real reasonable chance that a new attending funding a NG-457 will pay MORE taxes on distributions than they saved funding the plans. Better to save extra money (do new attendings have extra money??) in a brokerage account and have flexibility.
I wouldn’t go that far. If the investments are good, the fees are reasonable, the distribution options are reasonable and the employer is stable, I’d probably still use it. For most docs in their peak earnings years, a tax-deferred account is still the right move even if tax rates go up due to the filling the brackets issue.
https://www.whitecoatinvestor.com/roth-versus-tax-deferred-the-critical-concept-of-filling-the-brackets/
I have worried a bit about the ramifications of contributing to a 457b and moving jobs while in peak earning years. Even with receiving distribution 10 years while I’m at my peak earning years may be reverse tax arbitrage if it bumped me to the next bracket. But maybe that’s still better than putting after tax money and then having capital gains on top of that.
Seems like an easy workaround is to delay getting this deferred comp until you think you’ll reach retirement age. Most 457 plans have a clause to allow someone to access money “early” in the event of a major life event (like retirement), if I’m not mistaken. Also, the SEPP/72t rule also applies to 457 plans so that you don’t get penalized by the IRS.
There’s no early withdrawal penalty with 457s.
Depends on what the plan requires as far as distribution options. Some plans require it all to come out when you separate. I wouldn’t put much into a plan like that.
I maxed out my NG 457b plan for two years at my first job I left 8 years ago. I left it in there when I separated and checked the box to keep it in there for 15 years. I was planning on rolling it over to another NG 457b plan, but the chance never arose. Since then, the prior employer is looking like they’re having some financial problems. It’s now worth over $100k and I can’t access it.
I was able to petition my former employer to override this due to a legitimate personal reason. Something to remember if you’re in the position of wanting to withdraw and you have a circumstance that they former employer recognizes.
Thanks for sharing your experience. Bummer to have to take it all out at once, but better than not getting it at all.
Do you have a post on governmental 457 plans? I searched for it and did not find one. I have been putting the “catch up” max into a governmental 457B since about 2015 and it is now substantial, having had 20.8% average annual returns since 6/2015.
I have only about 8 more months to put money in it as I will retire to part time work in a different state in 8/2022 if our house sells in a timely manner. I can max out the yearly catch up amount again by then. It is the only money I will have access to before age 59.5 other than the proceeds from the sale of the house, although I plan to work part time for a year or two and will get over half of our new lower expenses from this work.
From what I can tell, I can take money from this after I retire from full time work with my current employer even if I stay on with them as an independent contractor. Also, I think that after I “retire”, that the money is mine and no longer “at risk” from any financial woes of my former employer, if it ever was? The employer is a government funded Community Mental Health Center.
It seems to me I should use some of the tax free (up to $500,000 ) house proceeds and earmarked savings to fund my new downsized existence in in a different state for the last quarter of 2022 and only pull money from this source in 2023, when my income will be reduced substantially to minimize taxes. Do the governmental 457 plans have this provision you mentioned from the state of origin to try to capture state tax revenue when you move away?
Think of a governmental one as an extra 401(k) without the age 59 1/2 rule.
Employer stability really not an issue with governmental plans as they are held in trust.
I’ve never heard of a state trying to recapture it and I don’t think they legally could.
I think of my NG457b as a short term “insurance policy” income replacement in the event of a family member’s severe illness or major injury. I have my own occupation DI policy, but we’ve had so many friends over the years who’ve sadly endured a major illness in a spouse, child, or parent—requiring they cut back on clinical duties. So I fund the NG457b with money set aside to replace income in the event I’d need to cut back to become caregiver at home for a while.
It will serve as a bonus retirement account if I never need it to replace income during my working years.
I guess if it allows withdrawals at any time it could work that way, but most of these require you to separate from the employer to get the funds. That’s not going to work for any emergency other than being fired.
In general, you are absolutely correct. My particular NG457b plan allows for in-service distributions due to unforeseeable hardships, such as:
• The loss of property caused by fire, flood or other catastrophic loss beyond the control of the participant or beneficiary.
• The imminent foreclosure of or eviction from the participant’s or beneficiary’s primary residence.
• A hardship need arising as a result of
an illness or accident of the participant, the beneficiary, such parties’ spouse or dependent or the participant’s designated primary beneficiary.
• The need to pay for medical expenses, including non-refundable deductibles, as well as the cost of prescription drug medication.
• The need to pay for the funeral expenses of a spouse, dependent, or non-dependent adult-child.
• Other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant or beneficiary.
I think most 457b plans have this provision, but this is definitely something to pay attention to when choosing whether or not to utilize the plan.
Excellent points.
I’ve been contributing to a non-governmental 457b for the last couple of years but had never considered that the timing of contributions could be influenced by the social security wage base. Can someone please clarify the potential advantages of this statement under point #1?: “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”
I’m having a hard time seeing how this would be advantageous… I guess if you’re strapped for cash and want to see that 6.2% stay in your paycheck as early in the year as possible, MAYBE it could be of benefit but after hitting the wage base you’ll also have to dedicate a larger percentage of each paycheck to your 457b contribution in order to catch up to your annual maximum, which, depending on annual salary, could easily negate all of this potential advantage (not to mention the lost growth potential from earlier contributions) . Theoretically, one could also have better investment vehicles that they want to prioritize first but anyone contributing to a non-governmental 457b has presumably already maximized all of their other pre-tax contribution options. Am I missing something here?
I don’t see a reason why either. Most docs are going to hit the max wage base either way. I don’t think you pay any more payroll taxes if you contribute to a 457(b) early in the year versus late. Maybe it’s because you feel like your paycheck is bigger later in the year because SS taxes aren’t being taken out of it?
I have to admit, I like this article on the 457 plans at FI Physician. https://www.fiphysician.com/non-governmental-457b/
For me, some key points are the following. For MANY 457 plans
#1) You can not roll them over, even into another 457 plan
#2) Often you HAVE to take a full disbursement of the ENTIRE amount 60-90 days after leaving the company
Look closely at the disbursement requiring else you may just have a Ticking Tax Bomb on your shoulders
1) True for all plans
2) Better find out if it is true for your plan before deciding to use it.
The KEY point is when the IRS deems your plan is “made available.” I was informed of this importance from a Nationwide retirement rep which holds my 457b. She informed me, much to my chagrin, that “made available” is not necessarily the same as distributions. (i.e. even if I chose a 5 year distribution my tax bill could be due 60 days from when I left the job). Here is some information on that issue from RIA
¶H-3302. When deferred compensation is “made available” under the section 457 plan rules.
Amounts deferred under a section 457 plan of a tax-exempt entity are includible in a plan participant’s (or his beneficiary’s) gross income for the tax year in which they are paid to, or otherwise “made available” to, the participant or beneficiary, see ¶ H-3301 .
RIA observation: Compensation deferred (and the income earned on these amounts) under
governmental section 457 plans is includible in income only when paid, and not when merely “made available.” On the other hand, participants in a section 457 plan maintained by a tax-exempt organization (other than a state or local government) have to include in their gross income amounts deferred under the plan when the amounts are either paid or otherwise made available (see ¶ H-3301 ).
Whether amounts deferred under a section 457 plan of a tax-exempt entity are considered “made available” to a participant or beneficiary in a tax year depends on whether:
. . . the plan’s terms allow a distribution for that participant or beneficiary for the tax year,
. . . a distribution is required under Code Sec. 457 (e.g., under the minimum distribution rules), . . . an initial deferral election was made that covers the tax year, or
. . . an additional deferral election was made for the tax year (if the deferral under an initial election would have expired), see below.
Amounts deferred in a section 457 plan are not considered “made available” solely because a participant can choose among various investments under the plan. 1
Unless an initial election ( ¶ H-3303 ) is made by a participant or beneficiary, 2 or a default schedule applies in the absence of an initial election (see below), and even if the participant or beneficiary may elect to receive a distribution in the circumstances described below, amounts deferred under a section
457 plan of a tax-exempt entity are considered “made available”:
(a) at the earliest date, on or after severance from employment (see ¶ H-3327.1 ), on which the plan allows distributions to begin,
(b) but in no event later than the date on which distributions must begin under the Code Sec. 401(a)(9) minimum distribution rules (see ¶ H-3332 ). 3
Well that’s interesting. And terrible. I wonder about the practical implementation of that concern. I have never had someone write in and ask about a problem with this sort of thing where they were planning to take it over 10 years but had to pay all the taxes in year 1.
Thanks for the words of commiseration, believe me I appreciate it. It just seems like there are a lot of nuances with the nongovernmental 457. Thanks for the work you do on the White Coat Investor. Really appreciate it!