[Editor's Note: This guest post is by a physician regular reader, Joshua Knudson, MD. We have no financial relationship.]
Focus has recently [actually back in February when this post was submitted-ed] been turned to places of which this blog may short shrift certain aspects of financial planning that are simply not a part of the primary author’s life. One area that was recently pointed out in An Invitation to Contribute was that regarding the 457(b). About the time that criticism was posted, I was in the process of evaluating a 457(b) available to me. Many self-employed or contractor physicians have all the tax advantaged saving space they need to save for retirement, but as more and more physicians become employees they will find themselves with limited retirement accounts. Additionally, their health insurance offerings may not permit a stealth IRA (HSA) further limiting their options.
As a single, employed physician with no dependents there are no 529s, spousal backdoor ROTH IRAs, SEP-IRAs or solo 401(k)s available to me. One option available to many physicians employed by a government or non-profit organization is a 457(b) plan. It has been briefly discussed in a previous Friday Q&A post but while that post touches on one main concern of the 457(b) more information is needed to determine if your employer’s plan is right for you.
How to Determine if your 457(b) Plan is Right for You
Similarities of the 457(b) To Your 403(b)
Many times these 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 18K per year
- Both are contributed to with pre-tax dollars providing a nice tax break
- Both grow in a tax-deferred manner
- Both are taxed as ordinary income upon distribution
- Often times the same investment options will be available in both
- Both require withdrawals to start at age 70 ½ with required minimum distributions
In one important way, the 457(b) is even better than 403(b). It has no penalty for withdrawing money prior to age 59 ½. The lack of the 10% early withdrawal penalty makes it an excellent source of income for a physician planning an early retirement.
Governmental vs Non-Governmental 457(b)s
But in many ways, the 457(b) can be exceedingly complex and the decision to use one isn’t as easy as it often sounds. Part of the difficulty is that there are different types of 457(b) which act in very different ways. Online articles and posts in the Bogleheads forum can easily lead you to incorrect conclusions on your plan if you do not understand the differences in the types of 457(b). The primary distinction is whether your 457(b) offering is governmental or non-governmental. Many state university employed physicians may have access to a governmental 457(b) whereas those of us working for non-profit employers will have a non-governmental plan. A governmental 457(b) does meet the definition of “essentially another 403(b)”. If your 457(b) is governmental one could easily make an argument it is even better than your 403(b) (fees and investment options not withstanding) and you generally should be making maximum contributions to them both each year. If your offering is of the non-governmental variety more consideration should be given prior to enrolling.
The largest and most important distinction between the plans, and the one discussed in the prior post, is that governmental plans are required to be held in trust and non-governmental plans are not. This means your money in a governmental plan is not exposed to the creditors of your employer whereas in the non-governmental plan assets remain controlled by your employer and thus are exposed to their creditors if they were to go under. While I agree with WCI that this risk is quite small, I’m sure the employees of Enron felt similar prior to the collapse of their employer. The risk, albeit small, is not zero. If you are not comfortable with the potential loss of this portion of your nest egg due to employer bankruptcy then you should not be using a non-governmental plan. For many, this could be reason enough not to use the plan and appears to be the main reason these plans seem not be favored on the Bogleheads forum.
Poor Distribution Options
If you are comfortable with your money being exposed to your employer’s creditors, you next need to determine how your plan will distribute your money. All plans are different in this regard. You must read all the details from your plan documents to understand how your plan works. Pay attention not only to how it is distributed upon retirement, but also if rules apply to termination of employment, both voluntary and non-voluntary. (If you think that can’t happen to you I’d be happy to provide you the contact information for the five physicians fired by my employer in the last few months alone.)
If you leave your employer, some plans will not let you leave the money with them and may require a lump sum distribution. Others may require you to notify them in writing within a certain number of days of termination your desire to leave the money with them or you will receive a lump sum. You cannot roll over the money from a non-governmental 457(b) into an IRA, a 403(b) nor a 401(k). Your only rollover option is if your new employer also has a non-governmental 457(b) AND that new employer’s plan accepts rollovers. Your plan may require lump sum distribution at the time of retirement or you may be allowed to choose to receive the money over a certain number of years. For example, my plan recently changed for the better. Originally upon retirement you had to take a lump sum payout from the plan. Now you can choose between lump sum or divided payments over five years. Each plan will be different and can be rather inflexible with the distribution options. This can make tax planning much more difficult.
No Roth in Non-Governmental 457(b)s
And don’t think you’ll just make ROTH contributions to avoid the tax bill on a lump sum distribution. They aren’t allowed in a non-governmental plan like they are in a governmental plan. Imagine, if you were fired in your early sixties after making maximum contributions to a non-governmental plan for 30 years, earning a conservative 5% growth rate, I would hate to see the tax bill on that 1.25 million dollar lump sum distribution taxed at your marginal rate.
Fewer Investor Protections
Further, admittedly of much less concern, 457(b) plans are not what is called a qualified retirement plan. Thus, they are not required to detail all fees and expenses like other retirement accounts. You could be exposed to a higher drag on your returns than you are aware of.
Learn Your Plan
As you can see, no two non-governmental 457(b)s will be the same and there is no blog post or web site to tell you if you should be using yours or not. You need to know all the details of your 457(b) prior to deciding to use it or not. Most importantly is your plan governmental or not. (Why two plans with very different rules have the same name is beyond me.) If your offering is a governmental 457(b) I’d count my lucky stars and treat it as an extra 403(b). If not, you need to determine if you are comfortable with the risk, albeit small, of losing your money to your employer’s creditors. If you are, next evaluate the investment options and fees of the plan. Keep in mind all the fees are not required to be disclosed as this is not a qualified retirement plan. If you are comfortable with the options and fees, pay attention to the withdrawal phase language. What happens if you leave this job? If your plan doesn’t allow you to leave the money and you don’t have a non-governmental 457(b) to roll the money into at your new job, you need to plan for a lump sum distribution. What happens when you retire? Are you prepared to take your account in a lump sum? Over five years? Ten? If you work for a very stable employer and expect to be there until retirement maybe their 457(b) is for you. If you value flexibility with your money and fear the tax implications of a lump sum distribution, maybe you’re better off with taxable investing or other options detailed elsewhere on the site.
[Editor's Note: I've inserted this illustration to demonstrate the decision-making process with a 457 outlined by Dr. Knudson above.]
Not a No-Brainer
As I’ve tried to show, I don’t think the choice to invest in your non-governmental plan is as simple as “tax savings vs risk of loss” discussed in the prior blog post. All this is not to say it can’t be a valuable piece of the retirement puzzle for many employed physicians with limited access to tax deferred accounts. If using a 457(b) for retirement savings, it should be the first account tapped to provide income for retirement due to the risk of loss. You must understand how your distribution rules could impact your taxes. Be sure to have a plan in place in case you are fired or desire to leave employment. If required to take a lump sum at retirement, you may be able to time it so that your distribution can be used to fill your lower tax brackets rather than added onto a year of earned income and taxed at your marginal rate. Also, remember that just because you have to take a distribution doesn't mean you have to spend it. You can reinvest the money in a taxable account or use it to buy Single Premium Immediate Annuities (SPIAs) to provide a lifetime of income.
For me, the tax break and lack of other tax-deferred account options make a non-governmental 457(b) plan too nice to completely ignore. Currently, about 10% of my retirement savings reside in one. I am comfortable with that amount of my nest egg being exposed to my employer’s creditors to get the tax benefits. However, the plan makes up 20% of my contributions to retirement savings this year and I do not think I am comfortable with that. At that rate, this account will grow to make up a larger portion of my nest egg over time and I’m not comfortable going beyond its current 10% level. As such, I am likely to pay down debt faster and/or increase my taxable investing with the money that would have gone to max out the account. That will allow me to sleep at night, all the while waiting for something to come along to cause a rewrite of my Investment Policy Statement (IPS) like a wife and kids or change in employer. What allows you to sleep sound at night may be quite different.
What do you think? Do you have access to a 457(b)? Do you use it? Why or why not?