If you just discovered you qualify for multiple retirement accounts you might ask yourself, can I max out my 401k and 457?
Yes, you can max out both your 401k and 457 plan up to the maximum allowed by the IRS which is $19,500 for each account. Contributing the max to both accounts results in a total tax deferral of $39,000 per year, not including catch-up contributions.
This is a great way to maximize your tax advantages for those looking to bulk up their retirement accounts quickly. If you decide to invest into both accounts your next question might be:
Should I Max Out My 401k or 457 First?
Most of the time it’s better to max out your 401k first since your employer can contribute a company match. Taking advantage of the company match is equivalent to a 100% return!
Unfortunately, your employer cannot match your contributions to the 457 plan. Therefore, you should only contribute to the 457 plan after you have taken advantage of the full company match in your 401k.
Here is a helpful flowchart I made on How To Prioritize Your Investments:
Maxing out both 401k and 457 accounts in the right order allows you to put the most money to work for you. The money won’t be going to Uncle Sam as an interest-free loan. Instead, it gets invested and flourishes through the magic of compound interest.
Let me show you an example of the difference that maxing out your 401k and 457 can have on your retirement plans.
A married couple making a combined $120,000 a year, decides not to max out their 401k or 457 and just invest in a taxable account.
To make things simple I am not including other taxes and deductions. They pay $12,837 in taxes and are left with $107,163. Their expenses are $38,000/year. Therefore, they are left with ($107,163 – $38,000 = $69,163).
With the $69,163 they invest it all into a taxable account where they make a return of 7% a year.
Using my Financial Independence Spreadsheet we can calculate that after 20 years their account has grown to 2.8 million.
In this scenario, the married couple making $120,000 a year combined, decides to max out both their 401k and 457.
They pay only $1,800 in taxes and are left with $40,200. Their expenses are $38,000/year, the same as before. Therefore, they are left with ($40,200 – $38,000 = $2,200).
Since they contributed the max to both accounts they already have $78,000 cost averaged into the market. They decide to throw in the remaining $2,200 into a taxable account.
Now they have a total of $80,200 invested and each year they make a return of 7%.
Now my Financial Independence Spreadsheet calculates that after 20 years their account has grown to 3.2 million!
A difference of $400,000!
This doesn’t include other benefits such as tax deductions in scenario B from having a lowered adjusted gross income (AGI). There are also taxes on the dividends in scenario A, while the money is growing tax-free in scenario B.
Another way to look at it is; scenario B had an extra $11,037 each year to invest. This extra money grew tax-free for 20 years into over $400,000.
To be fair, family in scenario B will have to pay taxes on this extra money. However, the tax liability should be a lot lower in retirement since you aren’t earning any income in the form of a W2 anymore.
You don’t have to fit into one of these scenarios, these are just examples of the two extremes. The take away is that investing through a tax-advantaged account helps you reach your retirement goals much faster. The more tax advantages the better!
The IRS allows you to max out your 401k and 457 so if you can do both that is fantastic!
What if you can only contribute to one or the other?
Which is better, a 401k or 457?
For most, the answer is your 401k. This is because employers usually do not match funds that are contributed to a 457 plan. Also, most people plan to retire after the age of 60. Therefore, the is no penalty for withdrawals from their 401k.
With 457 plans you may have limited investment options, which might also carry higher fees compared to your 401k choices. However, 457 plans have a unique option to take early withdrawals, penalty-free.
For us in the FIRE community, this means having access to your money a lot sooner. We don’t plan to work until we are 60 or older, so the 457 plan benefits may outweigh the benefits of a 401k.
This is also highly dependent on the investment options that are available in both accounts. I would suggest carefully considering the investment options and fees of both accounts, then making a decision that makes sense for you and your family.
This short video provides a great recap and can help highlight the best decision for you:
Lastly, take a look at how the IRS explains it if you want to go directly to the source!
If you qualify for both a 401k and 457 you can now create your scenario, but first I highly recommend reading Using a 457b Plan: Advantages & Disadvantages.
In that article, I detail exactly how to take full advantage of a 457 plan and how to avoid some of the pitfalls.
Planning for retirement using these accounts is not a one size fits all. The path you choose will be highly dependent on your options and financial goals. However, now that you are equipped with the knowledge you’ve gained from this article, you can create a scenario that works best for your family.
If you are still unsure, it might be time to reach out to a fee-only advisor for professional advice.
The peace of mind knowing you have a professional on your side helping you can significantly outweigh the costs.
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