A few years ago I stumbled across the 457b plan and today I’ll be giving you everything you need to know about using a 457b plan: advantages & disadvantages.
The advantages of a 457b are contributing more to retirement and early withdrawals. 457b disadvantages are the potential for limited investment choices and tax implications of lump-sum distributions.
We will go into these further but first, let’s go over some questions I initially had when I heard about the 457b plan:
What is a 457b plan?
A 457b plan is a tax-advantaged retirement account offered to certain government and non-for-profit company employees. There are 2 types of 457b accounts; governmental and non-governmental.
I only recommend using a governmental 457 b plan.
Do I qualify for a 457b plan?
If you work for a state, local government, or a tax-exempt organization chances are they offer a 457b plan to their employees. Your HR department should be able to provide you with an answer if you are still unsure.
If your employer does have a 457b plan available make sure to ask if it is governmental or non-governmental?
This is very important for reasons that I will make clear later.
Recently, I surveyed 40 of my co-workers. I asked if they were aware that our company offers a 457 plan for retirement. Shockingly, only 12 knew about it, and even worse only 4 were actively contributing towards it.
That’s only 30% awareness and 10% of them taking action!
Those numbers increased significantly afterward and now most are either contributing or working towards it.
Can I contribute to both a 401k and 457b plan?
Yes, you can contribute to both at the same time and up to the maximum allowed by the IRS, which in 2020 is $19,500 for each account.
If you contribute the max to each account you could defer $39,000 each year towards retirement. This is not accounting for any catch-up provisions.
After getting the answers to these questions I was thrilled to find out that my employer DOES offer us a 457b plan!
My employer offers a governmental 457b, which is the best kind of 457b plan.
Governmental vs Non-Governmental 457b Plan
As mentioned earlier, it’s very important to confirm with your employer whether your 457b plan is governmental or non-governmental.
- Governmental funds are yours and protected if your employer were to have any financial distress.
- Non-Governmental funds remain property of the employer until distribution.
So, if your plan is non-governmental and your employer files for bankruptcy, you will be fighting for your money against the company’s other creditors.
This increases the risk of using a non-governmental 457b plan. The worst-case scenario is job loss and losing all of your money in the account.
For this reason, I only recommend governmental 457b plans unless you are comfortable and clearly understand the risks laid out above. The remaining article focuses only on governmental plans.
So, let’s get into the details of the Advantages & Disadvantages.
Advantages of a 457b plan
Penalty-Free Early Withdrawals
You can withdraw from a 457b plan before the age of 59 ½ and penalty-free, as long as you no longer work for that employer.
Penalty-free early withdrawals are the reason a 457b plan is a perfect tool for us in the FIRE movement.
By combining this account with other strategies such as a Roth Conversion Ladder, you can minimize your tax liability and have access to your retirement account funds much earlier than the typical retirement age.
You Can Contribute To Both (401k/403b) & 457 b plan
The 457b plan allows you to defer an additional $19,500 to a tax-advantaged account. If you combine this with a 401k or 403b you can DOUBLE your contributions towards tax-advantaged accounts.
This allows you to defer pay taxes on up to $39,000 a year! It also means reaching your retirement savings goal much faster.
Pay Fewer Taxes
Contribution limits to a 457b plan are doubled for the final 3 years before attaining normal retirement age. This means that 3 years before “normal” retirement age, you can contribute $39,000 to your 457b plan.
If you are combining this with a 401k or 403b, you could contribute up to $58,500 to tax-advantaged accounts!
Possibly even more with the catch-up contributions from your 401k or 403b.
“Normal” retirement age for a 457 b plan is usually 50 years of age, but you should confirm with your human resources department.
Disadvantages of a 457b plan
Lack Of Good Investment Options
Depending on your employer, the investment choices could be limited and contain high fees.
Many 457b plan advantages can be negated if the only investment options you have contain high fees and poor quality investment.
Carefully research your options and if you are not satisfied you could lobby for better options through your HR department.
Should Not Rollover Into An Traditional IRA
If you roll the plan over to a traditional IRA you lose the advantage of penalty-free early withdrawals. So you should never roll your 457b plan into a traditional IRA. There simply is no benefit to it.
It’s better to ask your employer if you can leave the account open until you are ready to take your distributions.
Watch For Lump-Sum Distributions
A lump-sum distribution is sometimes the default choice when an employee gets terminated or leaves employment. This large distribution can lead to a hefty tax bill at the end of the year.
To avoid this, make it clear to the plan provider that you do NOT want your account funds to be distributed in a lump sum at any time.
You can send them this request in writing and keep a copy for your records.
457 b Plans For Financial Independence
If your employer offers a governmental 457b plan, you should carefully research it and make sure it works for you.
The 457b plan has some major advantages and disadvantages. However, I believe the advantages outweigh the disadvantages. If done right, you can take years off of your journey to early retirement!
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