Understanding 457 Plans: An Overview

What Is a 457 Plan?

A 457 plan is a tax-advantaged retirement savings plan designed primarily for employees of state and local governments, as well as certain nonprofit organizations. Among the varieties of 457 plans, the 457(b) is the most prevalent. Much like a 401(k) plan in the private sector, the 457(b) allows employees to save pre-tax earnings, consequently reducing their annual income taxes while deferring the taxes owed until retirement, when the money is withdrawn.

Understanding the Types of 457 Plans

The 457(b) is the key version of this retirement plan, promoting savings through pre-tax contributions. Additionally, it has a Roth counterpart, where employees can make after-tax contributions, allowing for tax-free withdrawals in retirement. On the other hand, the 457(f) plan operates as a supplemental plan, specifically designed for highly compensated executives in tax-exempt organizations.

Key Takeaways

• The 457(b) is an IRS-sanctioned, tax-advantaged employee retirement plan.
• It is available exclusively to public service employees and employees at tax-exempt organizations.
• Contributions grow tax-deferred, with taxes applying only upon withdrawal.

Contribution Limits

Employees participating in a 457(b) plan generally select investments such as mutual funds and annuities. They are allowed to contribute up to 100% of their salary, up to the IRS-set annual limit. For instance, for 2025, the contribution limit for a 457(b) is anticipated to increase to $23,500, up from $23,000 in 2024.

Moreover, individuals aged 50 or older can take advantage of a catch-up contribution limit of $7,500. Therefore, those eligible can potentially contribute as much as $31,000 per year ($23,500 + $7,500) in 2025.

The SECURE 2.0 Act, enacted in December 2022, introduced provisions allowing participants aged 60 to 63 to avail of higher catch-up contributions before the end of the tax year—either $10,000 or 150% of the typical catch-up limit. Additionally, the "double limit" provision permits participants to contribute double the annual limit for the last three years before reaching normal retirement age.

Important Notes on Distributions

The SECURE 2.0 Act also raised the age for mandatory withdrawals, known as required minimum distributions (RMDs), to 73 beginning in 2023. Those who turned 72 in 2023 must take their initial RMD by April 1, 2025.

Advantages and Disadvantages

Advantages

1. Flexible Withdrawal Rules: A significant advantage of a 457 plan is the looser regulations around early withdrawals. Participants can withdraw funds without penalties when they retire or resign, a stark contrast to many other retirement accounts.

2. Tax Deferral Benefits: Traditional contributions lower taxable income during the contribution years, with taxes postponed until withdrawals occur.

3. Penalty-Free Withdrawals: Unlike 401(k)s, where penalties may apply to early withdrawals, 457 plan holders can withdraw funds penalty-free for unforeseeable emergencies without changing jobs.

Disadvantages

1. Contribution Limitations: Employer contributions are common but may count toward the individual contribution limits, limiting potential savings compared to a 401(k) plan.

2. Investment Options: The investment choices in a 457 plan might be more limited than those in private-sector retirement plans, potentially leading to less diversification.

3. Vesting Schedules: Employer contributions may be subject to a vesting schedule, which can complicate retirement planning.

457(b) vs. 403(b)

Both 403(b) and 457(b) plans cater mainly to employees of public service sectors, such as educators and nonprofit workers. While 403(b) plans were initially limited to annuities, they have evolved to mirror 401(k) plans closely.

The key similarity lies in their contribution limits, which correspond to those of the 457(b) plan. However, the investment options available within each plan can vary significantly, particularly since 403(b) plans often offer a wider array of investment vehicles.

FAQs

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

The 457(b) plan, akin to a 401(k), allows public and nonprofit staff to save for retirement with a tax deferral. In contrast, the 457(f) plan, also known as a Supplemental Executive Retirement Plan (SERP), is geared exclusively towards high earners in the nonprofit sector, supplementing the benefits received from a 457(b) plan.

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

Both plans present advantages for retirement savings, allowing for tax-deferred contributions. Nevertheless, a key difference lies in employer matching; 401(k) plans typically offer matching contributions which can significantly boost savings.

How and When Can Employees Withdraw from a 457(b) Account?

Withdrawals from a 457(b) can occur without tax penalties in cases of “unforeseeable emergencies.” Participants must also adhere to RMD rules established by the IRS once they reach a certain age.

The Bottom Line

In summary, a 457(b) plan serves as an invaluable financial tool aimed at employees of government agencies and select nonprofit organizations. By offering various benefits, such as tax deferral and flexible withdrawal options, it promotes effective retirement savings. Individuals should carefully weigh the advantages and limitations before deciding if a 457(b) plan aligns with their retirement savings strategy.