The 457 plan is a type of non-qualified tax advantaged deferred-compensation retirement plan that is available for governmental and certain non-governmental employers in the United States. The employer provides the plan and the employee defers compensation into it on a pre-tax basis. For the most part, the rules for 457 plans are similar to those for 401(k) and 403(b) plans. Employees who are closer to retirement age can often contribute more to the 457 plan than younger workers.
The 457 plan is named after Section 457 of the Internal Revenue Code, which establishes the rules for deferred compensation plans for non-profit organizations and state and local governments. The 457 plan is similar to the 401(k) and 403(b) plans, but there are some key differences that can make the 457 plan more attractive to some employees, particularly those who expect to retire or otherwise leave their current employer before they reach the age of 59.5.
Understanding the Basics of a 457 Plan
The 457 plan is a type of retirement plan that is especially popular among government employees. It allows them to put a portion of their salary into a separate account, before taxes are taken out. The money in this account is then invested, and any returns or earnings are also tax-deferred, meaning that the employee doesn’t have to pay taxes on them until they start taking distributions in retirement.
There are two types of 457 plans: 457(b) and 457(f). The 457(b) plan is available to state and local government employees, as well as employees of some non-profit organizations. The 457(f) plan is available to top executives at non-profit organizations. The rules and contribution limits for these two types of plans are different, so it’s important for employees to understand which type of plan they have.
457(b) Plan
The 457(b) plan is the more common type of 457 plan. It is available to any state or local government employee, and to employees of certain non-profit organizations. The 457(b) plan has a contribution limit, which is the maximum amount that employees can contribute to the plan each year. In 2021, the contribution limit is $19,500, or $26,000 for employees age 50 or older.
One of the key advantages of the 457(b) plan is that there is no early withdrawal penalty. This means that if an employee leaves their job, they can start taking distributions from the plan, regardless of their age, without having to pay a penalty. This is different from other types of retirement plans, like the 401(k) and 403(b), which impose a 10% early withdrawal penalty if the employee starts taking distributions before the age of 59.5.
457(f) Plan
The 457(f) plan is less common than the 457(b) plan. It is available to top executives at non-profit organizations. Unlike the 457(b) plan, the 457(f) plan does not have a contribution limit. This means that executives can defer a larger portion of their compensation into the plan.
However, the 457(f) plan has a “risk of forfeiture” clause. This means that if the executive leaves their job before a certain date, they could lose all or part of the money that they have deferred into the plan. This is a significant risk, but it is also a powerful incentive for executives to stay with their organization for a longer period of time.
Benefits of a 457 Plan
There are several key benefits to participating in a 457 plan. The first is the ability to defer income taxes. Because contributions are made on a pre-tax basis, they reduce the employee’s taxable income, which can result in significant tax savings. Additionally, any returns or earnings on the investments in the plan are also tax-deferred, meaning that they are not taxed until the employee starts taking distributions in retirement.
Another major benefit of the 457 plan is the lack of an early withdrawal penalty. Unlike other types of retirement plans, employees can start taking distributions from a 457 plan at any age, without having to pay a penalty. This can be a significant advantage for employees who plan to retire or otherwise leave their job before the age of 59.5.
Contribution Limits
The contribution limits for a 457 plan are the same as those for a 401(k) and 403(b) plan. In 2021, the limit is $19,500, or $26,000 for employees age 50 or older. However, 457 plans have a unique “double limit catch-up” provision that allows employees who are within three years of their normal retirement age to contribute twice the annual limit, or $39,000 in 2021.
It’s also important to note that if an employee participates in both a 457 plan and a 401(k) or 403(b) plan, they can contribute the maximum amount to both plans. This is different from the rules for 401(k) and 403(b) plans, which have a combined contribution limit.
Investment Options
457 plans typically offer a variety of investment options. These can include mutual funds, annuities, and individual stocks and bonds. The specific options available will depend on the plan provider, but they usually include a range of choices to suit different risk tolerances and investment strategies.
Employees can usually change their investment choices at any time, although there may be some restrictions or fees associated with certain changes. It’s important for employees to review their investment options regularly and to make adjustments as necessary based on their age, retirement goals, and market conditions.
Drawbacks of a 457 Plan
While there are many benefits to participating in a 457 plan, there are also some drawbacks. One of the main drawbacks is the limited investment options. Unlike an Individual Retirement Account (IRA), where you can invest in virtually anything, 457 plans typically have a limited number of investment options. These options are usually selected by the plan provider and may not include the specific investments that an employee would prefer.
Another drawback is the risk of forfeiture associated with the 457(f) plan. If an executive leaves their job before a certain date, they could lose all or part of the money that they have deferred into the plan. This is a significant risk, but it is also a powerful incentive for executives to stay with their organization for a longer period of time.
Limited Investment Options
As mentioned above, one of the main drawbacks of a 457 plan is the limited investment options. The specific options available will depend on the plan provider, but they usually include a range of mutual funds, annuities, and individual stocks and bonds. While this can provide a decent amount of diversification, it may not include the specific investments that an employee would prefer.
For example, an employee might want to invest in a specific sector or industry, or in a specific type of investment like real estate or commodities. These types of investments may not be available in a 457 plan. Additionally, the fees associated with the investment options in a 457 plan can be higher than those for similar investments outside of the plan.
Risk of Forfeiture
The risk of forfeiture is a significant drawback of the 457(f) plan. If an executive leaves their job before a certain date, they could lose all or part of the money that they have deferred into the plan. This is a significant risk, but it is also a powerful incentive for executives to stay with their organization for a longer period of time.
The specific terms of the risk of forfeiture clause will vary by plan, but they typically require the executive to stay with the organization for a certain number of years. If the executive leaves before this time, they could lose all or part of their deferred compensation. This can be a significant drawback, especially for executives who are considering a job change.
How to Start a 457 Plan
Starting a 457 plan is relatively straightforward. The first step is for the employer to establish the plan. This involves selecting a plan provider and setting up the plan documents. The employer will also need to decide which employees are eligible to participate in the plan.
Once the plan is established, employees can start making contributions. These contributions are made on a pre-tax basis, which means that they reduce the employee’s taxable income. The money in the plan is then invested, and any returns or earnings are also tax-deferred.
Choosing a Plan Provider
The first step in starting a 457 plan is for the employer to choose a plan provider. This is typically a financial institution like a bank or brokerage firm. The plan provider will manage the plan’s investments and handle the administrative tasks associated with the plan.
When choosing a plan provider, it’s important for the employer to consider the provider’s fees, investment options, customer service, and reputation. The employer may also want to consider whether the provider offers other services, like financial education or retirement planning assistance, that could be beneficial to employees.
Setting Up the Plan
Once the employer has chosen a plan provider, the next step is to set up the plan. This involves creating the plan documents, which outline the rules and procedures for the plan. The plan documents will specify things like who is eligible to participate in the plan, how much employees can contribute, and when employees can start taking distributions.
The employer will also need to establish a trust for the plan’s assets. This trust will hold the plan’s investments and ensure that they are used solely for the benefit of the plan’s participants. The employer will need to appoint a trustee to manage the trust. This can be the plan provider, or it can be a separate entity.
Conclusion
In conclusion, a 457 plan can be a powerful tool for retirement savings, particularly for government and non-profit employees. The ability to defer income taxes and the lack of an early withdrawal penalty can make these plans particularly attractive. However, like all retirement plans, 457 plans have their own set of rules and restrictions, and it’s important for employees to understand these before deciding to participate in a plan.
While this guide provides a comprehensive overview of 457 plans, it’s always a good idea to consult with a financial advisor or retirement planning professional before making any decisions about retirement savings. They can provide personalized advice based on an individual’s specific circumstances and goals.
