All About Deferred Compensation 457 Plans
A 457 plan is a lesser-known retirement plan similar to a 401k. But these types of plans come with some added benefits.
First off, it’s worth noting that there are two versions. The 457(b) plan is the more common of the two. The other is the 457(f) plan. Both are IRS-sanctioned, tax-deferred plans. Those who partake are allowed to contribute up to the elective deferral limit of $19,500. But in some cases, workers are allowed to contribute even more. And because these are tax-advantaged plans, that means the interest and earnings aren’t taxed until the funds are withdrawn.
The big difference between the two is who qualifies for them. The 457(b) plan is typically offered to state and local government employees as well as some nonprofit employees. Firefighters, teachers and prison guards are examples of the types of jobs that qualify… that is, if their employer offers a 457 plan. But typically, most government employees not working at the federal level qualify.
The 457(f) plan is even more restrictive. This is offered to select highly compensated government and nongovernment employees. The government created these to help executives defer payment of federal and state income tax that is contributed to their account.
Three Big Benefits of a 457 Plan
Due to the fact that contributions to a 457 plan use pretax dollars, a worker’s total taxable income for the year is reduced. And that can be advantageous come April 15 when it’s time to file your taxes.
Another benefit to 457 plans is they offer “catch-up” deferrals. What this means is that people above 50 can contribute an additional $6,500 a year to their plan. There is also a special “last-three-years catch-up.” In this case, those who are within the last three years of retiring can contribute twice the annual limit to their retirement account… That means up to $39,000 can be reduced from your taxable income a year.
While the two benefits mentioned above aren’t completely unique to 457 plans, what separates this strategy from other retirement plans is the ability to make penalty-free withdrawals. The only catch is that you will need to pay taxes on any money pulled out of the account. But that’s the case no matter when the money is withdrawn.
In most cases, anyone under the age of 59 1/2 will pay a 10% penalty for any early withdrawals from a standard 401(k) plan. So if someone were to pull $10,000 out of a 401(k), they’d wind up with just over $6,000 after taxes and penalties.
But when it comes to a 457 plan, access to those pretax funds is much easier. If a person working for an employer that offers a 457 plan leaves their job, no problem. They can opt to roll the funds into another retirement plan. Or cash out the account whenever they want… free from any penalty. It’s just the taxman they have to worry about.
The Restrictions of This Retirement Plan
While one of the benefits of a 457 plan is reducing taxable income, you might not be able to max it out in all cases. Employer-matched contributions also count toward the allowable limit. If an employer contributes $4,000 to your 457 plan, you’ll most likely be able to contribute and reduce your tax burden by only $15,500. Still, not a bad problem to have.
The other major drawback to 457 plans is they aren’t known for their robust offerings. Most of them offer only a couple of choices when it comes time to pick an investment strategy. In fact, some offer only annuities.
But many also offer access to mutual fund custodial accounts, too. The problem with this is they can come with high fees and hidden costs. So, when looking into a 457 plan, pay attention to the details. Because as they say, the large print giveth, but the small print taketh away. That is why it’s vital to explore all of the costs that come with a new 457 plan.
The Bottom Line on 457 Plans
All in all, a 457 plan can be an excellent direction to take on the road toward retirement. A reduced tax burden, high contribution limits and the opportunity to withdraw from the account penalty-free make it an exceptional option.
But like all things in life, keep an eye on the details. Outsized fees and hidden costs can do a real number on your retirement plans. So do your homework and make sure the 457 plan you have access to makes sense for you. If not, you could be wasting a lot of compounding potential.
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About Matthew Makowski
Matthew Makowski is a senior research analyst and writer at Investment U. He has been studying and writing about the markets for 20 years. Equally comfortable identifying value stocks as he is discounts in the crypto markets, Matthew began mining Bitcoin in 2011 and has since honed his focus on the cryptocurrency markets as a whole. He is a graduate of Rutgers University and lives in Colorado with his dog, Dorito.