[Editor's Note: This post is from the newest member of the WCI Network, The Physician Philosopher. I've written before about 457 plans but this post gives The Physician Philosopher's take on whether the benefits of a 457 plan are worth the risks. ]
Should I invest in my 457 deferred compensation plan? That’s a tough question. While a 457 plan has some great features (like being able to use a 457 in early retirement without the 10% fine a 401K experiences), whether you should use it or not is complicated. It’s just not the same as answering whether or not you should invest in your 403(b) or 401K. If you are asking if you should use your 457, this is the post for you.
Let’s dig in.
What is a 457?
Just like any other retirement plan with numbers, this comes from the part of the IRS tax code (section 457) for deferred compensation plans. It is a “deferred compensation plan” that allows you to make pre-tax contributions and will allow your earnings to grow tax-free while in place.
There is an important distinction, and I am going to make it early. There are two ways you can qualify for a 457.
The first is that you work for the government and are provided a governmental 457. The other way you can have access to a 457 is through a non-governmental employer, which grants you access to a non-governmental 457.
While the governmental and non-governmental 457’s have some similarities, there are also some very important differences. This post will help you sort it all out and give you a clear answer on whether you should use your 457 plan or not.
The following are some details that are similar to both a governmental and non-governmental 457 (NG-457):
Applies to All 457s
Contribution limits for 457 plans are $19,000 for most. For some over the age of 50, you may be able to contribute more (possibly as much as $37,000 if within three years of retirement age for your plan).
All 457’s may be transferred from one 457 to another (governmental to governmental; non-governmental to non-governmental). However, the receiving plan must accept transfers.
You must take payments by April 1st following year of retirement or age 70.5 years old (whichever happens later).
Governmental 457’s may be rolled over to eligible retirement plans (i.e. IRA’s). NG-457’s cannot be rolled into an IRA.
Age > 50 catch-up contributions are only available for governmental 457s.
NG-457’s are “Top-Hat” plans and must limit the number of people who can participate to “groups of highly compensated employees or groups of executives, managers, directors or officers.”
Governmental 457’s often allow Roth contributions. NG-457’s do not allow Roth contributions…otherwise this would be a great way to avoid the possible tax consequences of bad distribution options, which are discussed more below.
This is the most important difference: Governmental 457s are backed by the US government (NG-457s are backed by individual institutions and are available to creditor’s upon legal action or bankruptcy). This is the exact wording from the IRS on non-governmental 457s:
“[Non-governmental] Plan assets are not held in trust for employees, but remain the property of the employer (available to its general creditors in the event of litigation or bankruptcy)….Employees are lower in priority than general creditors in the event of legal claims against the employer.”
What this last bullet point means is that if your institution goes bankrupt or into major litigation, your hard-earned retirement money is available to creditors.
This is very different from your typical 401K or 403B which is not only protected from employer litigation, but often protected even in most personal litigation (i.e. medical malpractice cases).
Why Should You Consider Investing in a 457?
There are certain tax benefits associated with participating in a 457. This includes being able to contribute pre-tax money to decrease your overall tax burden. The gains also grow tax-free. Your only taxation occurs when you take it out. This all sounds exactly like your standard (pre-tax) contributions to a 401K and 457.
If you have a governmental-457, this is backed by the government. If the government defaults, we are all in trouble. The market would likely crash.
This provides some comfort for those with a governmental 457. In fact, I would argue that you could view a governmental 457 as a second 401K or 403B. It’s just as safe and provides many of the same benefits. Congrats, if you have one! Don’t think twice, go use it.
For example, my wife works full-time as an early learning childhood coach (i.e. coach for kindergarten teachers). So, while she has access to a 401K (which we also use), we preferentially prefer her governmental 457, which can be used in early retirement, unlike a 401K.
So, first, we fill up her governmental 457 with $19,000 and put any remaining money left from her salary towards her 401K. While we focus much more on financial independence than early retirement, the 457 will be accessible to us in early retirement if we went that route.
Non-Governmental 457’s Are Not the Same: What You Should Consider
The differences between a governmental and an NG-457s may seem small, but nothing could be less true. If you have a governmental 457, go contribute if it has good options.
If you have an NG-457, you need to make sure your specific plan doesn’t have the following three problems before participating.
Remember, you are comparing investing in an NG-457 to a taxable/brokerage account where you’ll be paying taxes on the gains. So, if any of the following look problematic, I’d prefer a taxable account.
Reason to Pause #1: Poor Financial Situation
Remember, your NG-457 money is available to creditors.
Combine this with the fact that most of us do not have inside information on our employer’s financial situation. That makes for an uncomfortable and sleepless situation. If you don’t think your employer can close up shop, ask physician on fire.
So, before you contribute to your NG-457, you should be intimately familiar with your employer’s financial situation. What’s their bond rating? How much cash on hand do they have? Have there been any recent changes that would lead you to believe there are financial troubles?
Reason to Pause #2: Bad distribution options
The distribution options are sometimes terrible. You cannot contribute via Roth to non-governmental 457s. Therefore, you are likely to foot a huge tax bill if you leave your employer unless your new employer accepts transfers (not always the case).
Many 457 distribution plans require you to take the lump sum upon leaving. That’s a huge loss to taxes. Who wants to pay taxes on an additional $250,000-500,000 when you retire or leave your employer? That’s what happens if you are forced to take the lump sum.
So, if the lump sum is the only option, consider using a taxable account instead.
In order to know the specific options your 457 offers, request the plan documents and read them thoroughly. Ask questions. Make sure you understand exactly what is being offered.
Reason to Pause #3: Poor Investment Options
Some 457 plans have high-expense ratio funds, and nothing else. If this is the situation, don’t feel forced to take advantage of the tax savings just to invest in bad funds.
Instead, pay the taxes, know that your money is yours, and cut your ties.
However, if your plan has low-cost index fund options, and the first two reasons to pause haven’t tripped you up, it’s definitely worth considering the use of your NG-457 plan.
Take Home: When Should You Participate in a 457?
If you have a governmental 457
The answer is easy. If you have the income, then you should participate. It’s essentially an extra 401K/403B.
After you fill up your 401K/403B, the governmental 457 should be the next retirement space you fill up. If you have room after that, then a stealth (HSA) IRAa and backdoor Roth IRA are your next bets. Then a taxable account. Governmental 457’s make life easy.
If you have a non-governmental 457
All of the following assumes that your 457 has good options in which to invest (i.e. low expense-ratio passively managed index funds).
The answer becomes more complicated. The one thing that I can tell you that no one would disagree with is that you should be intimately familiar with your employer’s 457 plan. Ask for it. They are required to give it to you by law.
Also, in my opinion, you should contribute to your 401K/403B, stealth (HSA) IRA, and backdoor Roth before you consider a non-governmental 457. Those offer better features with less risk.
I would not participate in a non-governmental 457 unless I was satisfied with number 1 and number 2 above in the section above on what should give you “pause.” You must be very confident of your employer’s financial situation and stability. If you have any concerns, then don’t participate in your 457. A taxable account is a better option in this situation.
If you are okay with your institution’s financial situation and stability, then check the distribution options. If they don’t let you a) keep the money in or b) take the money over a period of years… then, again, I would hesitate to participate in that 457. The up-front tax-benefit will likely be a wash if you have to take it all out quickly at the end. For those who plan to leave their current employer or plan to FIRE (retire early), the 457 is not a great option unless your distribution options are solid.
That said, if you are happy with your employer’s financial situation, the NG-457 offers good investment options, AND the distribution options are reasonable… then this may be a good way to fill the gap before age 59.5 when you can access your 401K/403B.
The 20% You Need to Know
I’d consider this part of the 20% of personal finance that you need to know to get 80% of the results.
I realize this is a contentious topic. What are your thoughts? I’d love to hear them, particularly if you disagree with my assessment. Do you contribute to your non-governmental 457? If so, does it meet my criteria?