What Is a 457 Plan?

What Is a 457 Plan?

A 457 plan is a tax-advantaged retirement savings plan that is offered to certain employees of many state and local governments and of some nonprofit organisations. In many ways, a 457 plan is similar to a 401(k) plan, which is the retirement-savings vehicle most common in the private sector. It allows the employee to place a portion of her before-tax earnings into an account that will reduce her income taxes for that year. The taxes will be postponed until after the money is withdrawn in the years after she leaves work.

An employer might allow an after-tax Roth version of the 457 plan (known as salary deferral) as an additional option.

There are two main types of 457 plans:

The 457(b): This is the most common 457 plan, offered to state and local government and for employees of nonprofits. It allows employees to save money for retirement on a tax-deferred basis.

Another option for employers who want to provide more flexible savings and accumulation options for their employees is a 457(f). This plan is available only to executives who are highly compensated in tax-exempt organisations; it is an add-on to the 457(b) and is, essentially, a supplemental deferred compensation plan.

Key Takeaways

The 457 plan is an IRS-sanctioned, tax-advantaged employee retirement plan.

The plan is offered only to public service employees and employees at tax-exempt organizations.

The employers permit the workers to donate from 0 to 100 per cent of their salaries (subject to a dollar cap for the year).

Interest earnings have never been taxed, and neither are they taxed when the savings are withdrawn: the only part that is taxed is what is deposited. (The Roth option, if available, deposits only post-tax money.)

Types of 457 Plans

As noted, the 457 plan comes in two flavors, the 457(b) and the 457(f).

The 457(b) Plan

The 457(b) plan is offered to civil servants, police and many other employees of all levels of government agencies, public utilities, public services, nonprofit organisations such as hospitals, churches, charitable organisations.

It operates much like a 401(k). Contributors set aside a portion of their paycheck into a retirement plan. It’s up to the workers to choose among a menu of investment options in their 401(k) to determine what to buy with their earnings, the main choices being mutual funds and annuities.

It gains value tax free over time and then, getting no longer qualified, the employee withdraws the account, on which they need to pay taxes.

Employees have the option to contribute a percentage of their earnings, as long as it doesn’t exceed the dollar limit established for that particular year.

If the 457 plan doesn’t satisfy statutory requirements, the assets could be subject to different rules.

457(b) Contribution Limits

Employees contributed a maximum of $22,500 annually to 457 plans in 2023, but in 2024 this amount will increase to $23,000.

In either case, the employer may allow up to $7,500 more (in 2023), from workers aged 50 and older – a so-called ‘catch-up’ contribution that allows for a maximum contribution of $30,000 (2023 figure: $22,500 + $7,500) and $30,500 (2024 figure: $23,000 + $7,500), respectively, during those respective tax years.

Moreover, 457(b) plans have a so-called ‘double limit catch-up’ provision to allow participants nearing retirement age to make up for previous years in which they did not contribute but could have.

Here, workers are up to age 81, but only three years from their retirement date, and can contribute $45,000 in 2023 and $46,000 in 2024.

Advantages and Disadvantages of a 457(b) Plan

The 457(b) retirement plan has the same benefits as the 401(k), with the addtional distinction, doing domething else.

Advantages of a 457(b)

Tax Benefits

A traditional rather than a Roth plan deducts money from an employee’s paycheque on a pre-tax basis. That amount is then subtracted from the employee’s gross income, thus resulting in less tax paid for that year. Let’s go back to Alex, who earns $4,000 per month. If Alex contributes $700 to a 457(b) plan during that month, Alex’s taxable income for the month would be $3,300.

Workers put their contributions into one of several annuities or mutual funds offered by their chosen charity.

All interest generated, year on year, is likewise tax-free until you take money out.

Withdrawals Without Penalty

It is only one significant feature that distinguishes the 457(b) from many other tax-advantaged plans, such as IRAs, that do apply an early-withdrawal penalty: your ability to take a withdrawal without penalty, in certain situations.

If the person to whom the funds have been allocated chooses to retire before reaching the normal retirement age and eventually close their IRA, or if they quit their job for any reason, they can withdraw the funds without having to pay the 10 per cent penalty that the IRS otherwise levies for premature distribution from most retirement plans (with several exemptions for hardship cases – the penalty was dispensed with for a period of two years during the COVID-19 pandemic).

A participant with a 457(b) account has freedom to take a penalty-free withdrawal without changing jobs – albeit offered with fewer reasons listed under ‘unforseen emergencies’.

Exceptions to the Rules

Early withdrawals from a 457(b) are also subject to the standard 10 per cent penalty if an account holder rollovers the funds from a 457 to another tax-advantaged retirement account, such as a 401(k). This would happen if, for instance, a government worker quit to take a job in the private sector.

Second, any person who takes money from a retirement account before he or she reaches age 59½ should recognise that any taxes owed on that money will be owed in the year in which the distribution is taken.

Disadvantages of a 457(b) Plan

One reason that most tax-advantaged retirement savings plans can help you is that your employer might match some part of the amount that you put into the plan. If your employer matches the first 3 per cent that you contribute to the plan, for instance, he or she is in effect giving you a 3 per cent raise.

Employer Match Is Rare

Employers can match their employees’ contributions to a 457(b) but, in practice, most don’t.

If they do, the employer contribution counts toward the maximum dollar limit. This is not the case for the 401(k) plan.

For example, if an employer contributes $10,000 to a 457(b) plan for the employee in 2023, the employee can add only $12,500 for the year ($22,500 contribution limit minus the $10,000 employer contribution) until the $22,500 contribution limit for the year is reached, except those aged 50 and over can use the catch-up option.

457(b) Advantages

Looser rules for early withdrawals without a penalty.

Early distributions allowed for participants who leave a job.

As with other retirement plans, no taxes are due until money is withdrawn.

457(b) Disadvantages

Employer contributions count toward contribution limit the year they vest.

Employer contributions subject to vesting schedule. If the employee quits, non-vested funds are forfeited.

Limited investment choices compared to private sector plans.

457(b) vs. 403(b)

The 403(b) plan is similar to the 457(b) to the extent that both plans are largely available to public service employees and they are both commonly offered as benefits to public school teachers.

It has been around since the 1950s and was previously a 403(b) plan, widely used by not-for-profit companies and educational institutions. Back then, 403(b)s provided only an annuity to their participants. In fact, participants could still establish an annuity, but they can also invest in mutual funds.

Indeed, the 403(b) has evolved over time until now it resembles the private sector’s 401(k) plan, although the number and type of investment opportunities offered to participants are relatively limited.

The annual contribution limits are identical to those of the 457(b) and 401(k) plans.

If you’re a public employee, your boss will likely have a 457(b) or a 403(b).

Advisor Insight

Dan Stewart, CFA®

Revere Asset Management, Dallas, TX

And 457 plans are taxed upon distribution just like a 401(k) or 403(b), just with no withdrawal penalties. However, if you like, you can roll the assets into an IRA and smooth distributions over your lifetime – maybe taking them only when you really need them.

Thus, if you want to take the whole package as a lump sum, the entire amount goes on your income and may push you to a higher tax bracket.

With the rollover route, you can take out a little this year, and so on as necessary, thus keep better control of taxes. And as long as it is inside the IRA, it’s growing tax-deferred and it’s generally secured from creditors.

What Is the Difference Between a 457(b) Plan and a 457(f) Plan?

The 457(b) plan is the public- and nonprofit-worker version of the 401(k) plan, which allows employee savings for retirement, but defers the tax bill (until retirement, when the money can be withdrawn). The Roth version of this, if an employer chooses to offer it, pays the taxes upfront – there’s usually no tax bill associated with withdrawals.

As for its 457(f) plan, or the ‘SERP’ (irement Plan) for the top-paid tax-exempt managers, well, here again we have a retirement account – this one for the top executives in the tax-exempt sector, primarily in hospitals and universities, but now expanding to credit unions as well.

A 457(f) is a supplement to a 457(b). An employer pays extra amounts to the employee’s account under a 457(f), above and beyond the limits of the ordinary 457(b). These amounts are negotiated with a contract and are, in effect, a deferred salary adjustment.

If he resigns before a set and final vesting period, the 457(f) contribution evaporates — or 457(f) plan purists would contend, would be ‘forfeited’. This plan is only supposed to benefit executives. It is the prototypical ‘golden handcuff’.

Is a 457(b) Plan Better Than a 401(k) Plan?

For all practical purposes, however, a 457(b) is as good as any 401(k) plan. If your agency is public (and non-profit), it’s your best bet.

Assuming you go with a traditional plan rather than a Roth one, you’ll be reducing your taxable income annually while depositing that money into a long-term investment account that won’t be taxed until time comes to start drawing against it, ideally when you’re retired.

(A Roth, if that’s what it is, you’ll pay the taxes on it up front and will generally owe no taxes on what you put into it or on the proceeds it earns over the years.)

The downside is, your contributions will probably not be matched by your employer. But that’s the way the nonprofit world works, not some rule of the plan.

Next, look beyond the 401(k) and consider funding a supplementary individual retirement account (IRA). The maximum single contribution for 2024 is $7,000 if you’re under 50 years of age, and $8,000 if you’re 50 or over.

How and When Can I Make Withdrawals From My 457(b) Account?

One of the benefits of a 457(b) is that you can take out early withdrawals penalty free due to an unforeseeable emergency. This isn’t a great idea – hey, you’re pillaging your retirement funds – but unforeseeable emergencies can happen. And you’ll pay income tax for the year on what you withdraw.

The RMD number is determined by an IRS worksheet. This is a Required Minimum Distribution (RMD). An RMD is the minimum amount that you have to take out of specific retirement plans, in this case a 457(b), each year after a certain age. Age 73 if your year of birth is between 1951 and 1959; age 75 if your year of birth is 1960 or after. This is an increased age from the previous RMD of age 72.