What is a 457(b) Plan?

A 457(b) plan is a deferred compensation retirement plan primarily available to employees of state and local governments, as well as certain non-profit organizations. It functions similarly to other employer-sponsored retirement accounts like 401(k) and 403(b) plans, enabling participants to save for retirement with tax advantages. However, the 457(b) plan offers unique features, including more flexible withdrawal options and distinctive catch-up contribution rules, making it particularly beneficial for individuals in public service roles or eligible non-profit positions.

Key Features of a 457(b) Plan

Eligibility

The 457(b) plan is accessible to state and local government employees (e.g., teachers, police officers, municipal workers) and employees of certain tax-exempt organizations. It is not typically offered in the private sector, distinguishing it from more widely available plans like the 401(k). This focus on public sector and non-profit employees is central to its structure and benefits.

Contribution Limits

For 2024, employees can contribute up to $23,000 per year to a 457(b) plan. Those aged 50 and older are eligible to make an additional catch-up contribution of $7,500, bringing the total to $30,500. Additionally, the "special three-year catch-up" provision allows eligible participants nearing retirement to contribute up to $46,000 annually during the three years prior to their designated retirement age, provided they haven't maximized contributions in previous years.

Tax Advantages

Contributions to a 457(b) plan are made on a pre-tax basis, reducing taxable income for the year in which the contribution is made. This lowers the participant's current tax bill while allowing investments to grow tax-deferred. Taxes are paid upon withdrawal, typically during retirement when the participant may be in a lower tax bracket. Some 457(b) plans offer a Roth option, permitting participants to make after-tax contributions, with qualified withdrawals during retirement being tax-free. However, the availability of Roth contributions depends on the specific plan provisions set by the employer.

Investment Options

Most 457(b) plans provide a variety of investment options, including mutual funds, target-date funds, bond funds, and sometimes self-directed brokerage accounts. Participants can tailor their portfolios to align with their risk tolerance, investment goals, and retirement time horizon. The range of investment options is determined by the plan sponsor but is generally diverse enough to support a wide array of savings strategies.

No Early Withdrawal Penalty

457(b) plans permit penalty-free withdrawals upon separation from service, regardless of age. However, withdrawals are subject to ordinary income tax. This flexibility distinguishes 457(b) plans from other retirement accounts that typically impose a 10% early withdrawal penalty for distributions before age 59½. The absence of an early withdrawal penalty makes 457(b) plans particularly attractive to participants who may need to access their funds earlier than planned.

Rollover and Portability Options

Upon leaving employment, participants can roll over their 457(b) funds into another eligible retirement plan, such as an IRA, another 457(b), or certain other qualified plans. However, rolling over into a 401(k) or 403(b) may subject future withdrawals to the 10% early withdrawal penalty if taken before age 59½. This flexibility allows participants to maintain control over their retirement savings throughout career changes and life transitions.

How a 457(b) Plan is Used

Long-Term Retirement Savings

The primary purpose of a 457(b) plan is to help employees accumulate savings for retirement. By contributing on a pre-tax basis, employees reduce their taxable income for the contribution year and allow their investments to grow tax-deferred. Upon retirement, these savings can be used to cover living expenses, healthcare costs, travel, or other needs.

Strategic Tax Planning

Contributing to a 457(b) plan can be a strategic move for employees aiming to lower their taxable income during high-earning years. When funds are withdrawn in retirement, they are subject to ordinary income taxes, but participants may find themselves in a lower tax bracket at that time, reducing their overall tax burden. For employees who prefer tax diversification, some 457(b) plans offer a Roth option, enabling post-tax contributions and tax-free withdrawals in retirement.

Early Retirement Bridge

The absence of an early withdrawal penalty makes the 457(b) plan a popular choice for employees planning to retire early. The plan can serve as a bridge for individuals needing income before other retirement benefits, like Social Security or pension payouts, become available.

Supplementing Other Retirement Accounts

Employees with access to multiple retirement plans, such as a 457(b) and a 401(k) or 403(b), can maximize their contributions across all plans. By leveraging the combined contribution limits, participants can potentially save significantly more for retirement, accelerating their path to financial independence.

Estate Planning

Unused assets in a 457(b) plan can be passed on to beneficiaries, making the plan a valuable tool for estate planning. Beneficiaries may have options to continue deferring taxes on the inherited account, subject to specific distribution rules.

Pros and Cons of a 457(b) Plan

Pros

• Tax Advantages: Contributions lower taxable income, and earnings grow tax-deferred until withdrawal, significantly enhancing long-term savings growth.
• No Early Withdrawal Penalty: Unlike other retirement plans, the 457(b) plan does not impose a 10% penalty for early withdrawals before age 59½, providing flexibility for participants who may need to access funds earlier for emergencies, career changes, or early retirement.
• Special Catch-Up Contributions: The 457(b) plan’s special catch-up provision allows employees nearing retirement to increase their contributions dramatically, helping to bridge savings gaps.
• Roth Option Availability: Many 457(b) plans now offer a Roth option, allowing employees to contribute after-tax dollars and enjoy tax-free withdrawals in retirement, beneficial for those expecting to be in a higher tax bracket later.

Cons

• Limited Employer Eligibility: Only state and local government employees, along with certain non-profit workers, are eligible for 457(b) plans, limiting access compared to more broadly available plans like the 401(k).
• Potentially Lower Employer Contributions: Not all 457(b) plans include employer contributions. When they do, such contributions count toward the annual contribution limit. This differs from 401(k) and 403(b) plans, where employer contributions are often separate from employee deferral limits. This can impact the growth of an employee’s savings over time.
• Contribution Coordination: If an employee participates in both a 457(b) and another employer-sponsored plan (such as a 401(k)), their combined contributions are subject to annual IRS limits, potentially limiting how much can be saved in total.

Optimizing Contributions to a 457(b) Plan

1. Max Out Contributions: To maximize the tax-deferred growth and take full advantage of the plan’s benefits, employees should aim to contribute the maximum amount allowed by law each year. This not only reduces taxable income but also boosts long-term savings.
2. Leverage Catch-Up Provisions: Employees nearing retirement can use the special catch-up provisions to accelerate their savings. By doubling the contribution limits for up to three years before retirement, participants can close potential savings gaps and increase their retirement security.
3. Balance Pre-Tax and Roth Contributions: Determining whether to make pre-tax or Roth contributions depends on an individual’s current income and future tax expectations. A mix of both can provide tax diversification, allowing participants to better manage their taxable income during retirement.
4. Work with a Financial Advisor: Retirement planning can be complex, and a financial advisor can help tailor an individual’s strategy to their unique needs, optimizing contributions, investment choices, and eventual withdrawals.

Practical Scenarios for Using a 457(b) Plan

Retiring Early: The flexibility to access funds without a 10% early withdrawal penalty makes 457(b) plans an effective tool for those planning to retire before the age of 59½. This can help bridge the income gap before pension payouts or Social Security benefits kick in.

Tax Management During High-Income Years: Employees can contribute to a 457(b) plan to lower their taxable income during peak earning years. This deferral of taxes until retirement can result in overall tax savings, especially if they are in a lower tax bracket when they begin withdrawals.

Supplementing Other Retirement Plans: For employees with access to both a 457(b) and a 401(k) or 403(b), maximizing contributions to both plans allows for greater total savings, improving the potential for a comfortable retirement.

457(b) Plan FAQs

Can employers make contributions to a 457(b) plan?

Yes, employers can make contributions to a 457(b) plan, but it is less common than in 401(k) plans. These contributions may take various forms, such as matching employee contributions or making discretionary contributions on behalf of the employee. However, any employer contributions are subject to the overall annual contribution limits set by the IRS, which combine employee and employer contributions. While employer contributions can be beneficial, it’s important to understand that they may vary by plan, employer type, and individual plan rules.

What happens to a 457(b) Plan when an employee leaves?

When an employee leaves their position, they have several options for their 457(b) funds. Typically, employees can leave their funds in the existing plan, if permitted by the plan’s terms, or they can roll over their account balance into another eligible retirement plan, such as an IRA, another 457(b) plan, or even certain other types of retirement plans, like a 401(k). This rollover capability allows employees to maintain tax-deferred growth and consolidate retirement assets, simplifying their retirement strategy and reducing administrative costs.

Are distributions from a 457(b) plan subject to Required Minimum Distributions (RMDs)?

Yes, distributions from 457(b) plans are subject to Required Minimum Distributions (RMDs). Participants must begin taking RMDs by April 1 of the year following the year they turn 73 (for those turning 72 after January 1, 2023). The amount of the RMD is calculated based on the participant's life expectancy and the account balance as of December 31 of the previous year. Failure to take RMDs can result in significant penalties, including a tax of up to 50% on the required distribution amount that was not taken.