Question
I recently changed jobs and my new job offers both a 403(b) plan and a 457(b) plan. I know the 403(b) is a lot like the 401(k) I used to have, but what is a 457(b) and should I use it?
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ACEP Now: Vol 42 – No 02 – February 2023
Answer
A 457(b) plan, like a 401(k), 403(b), or traditional IRA, is a tax-deferred retirement savings account. The primary difference between a 457(b) plan and those other accounts is the owner of the account. With an IRA, 401(k), or 403(b), the account contains your money. In a 457(b), the account contains the money of your employer. This is money your employer has promised to pay you at some point in the future, but it is not technically your money yet. Think of it as deferred compensation.
Despite 457(b) money not being yours, you are still allowed to control how it is invested in the plan. Like a 401(k), a 457(b) typically allows you to choose between various mutual fund investments in the plan and change that mix of investments periodically. For this reason, most people think of it and treat it as just another 401(k). That is fine most of the time, but as with many things in finance, the devil is in the details. You need to understand the details, especially when deciding whether to use the account or not. You always have the option of not using any retirement account and simply saving for retirement in a taxable, non-qualified brokerage account where you have maximum flexibility and unlimited contribution amounts.
457(b) contribution limits are exactly the same as the employee contribution amount to a 401(k), $22,500 in 2023. Thus, a 457(b) allows many investors to double their tax-protected retirement savings annual contribution. There are catch-up contributions too, but they do not work exactly like 401(k) catch-up contributions. Some plans do not allow them at all. The IRS permits a plan to offer the same $7,500 per year catch-up contribution that 401(k)s have for individuals over age 50. However, it also allows 457(b)s to offer two other types of catch-up contributions instead, whichever is less. The first of these allows you to double your contribution in the last three years before retirement age ($45,000 per year). The second allows you to make up for any contributions you were allowed to make but did not make in the past.
A big advantage of a 457(b) over a 401(k), 403(b), or IRA is that there is no penalty for withdrawing the money before a certain age. Once you have left the employer, you can pull the money out penalty-free whether you are 40 or 70. Thus, 457(b) money is often some of the first money an early retiree spends. If you still have money in a 457(b) at age 72, you are required to take Required Minimum Distributions (RMDs) from it, just like a traditional IRA.
When deciding whether to use your 457(b) or not, the first question to address is whether the 457(b) plan is a governmental or a nongovernmental plan. Governmental plans are pretty much better in every respect, but perhaps the greatest advantage is that when you leave the employer, you can roll a 457(b) into a traditional IRA or other retirement account. That is not the case for a non-governmental 457(b). You might be able to roll it into another non-governmental 457(b), but you should assume that the money will be in this 457(b) until it is withdrawn. In addition, the assets in a governmental 457(b) are held in trust for the employee, just like a 401(k). That is not the case with a non-governmental 457(b). Those funds are subject to the employer’s creditors. For this reason a 457(b) provides excellent asset protection against your creditors, but it provides no protection at all against an employer’s creditors. I have been searching for years for a doctor who actually lost 457(b) money to an employer’s creditors and have not yet found one, but it is a theoretical risk. The bottom line is that if your 457(b) is a governmental 457(b) like that offered by most university hospitals, go ahead and use it just like another 401(k). If it is a non-governmental 457(b), you need to look at it more carefully before deciding to use it.
What Should You Look For? Four Things Primarily:
- Stability of the employer
- Distribution options
- Investment options
- Fees
Since this money is subject to the creditors of the employer, if the employer seems to be going bankrupt, you may want to limit how much money you put into the 457(b). While the upfront tax break is great, and tax-protected growth can really boost your after-tax investment returns, the return of your principal matters more than the return on your principal. If your employer is not paying its bills (and it cannot hide this fact long from the physicians and other staff working at a hospital), I would recommend against using the 457(b).
Next, check out what the distribution options are. Essentially, you want flexibility and the ability to spread out distributions over at least five years. Otherwise, you may end up having to take all of the money out in a single year and pay taxes on most of it at a high rate. 457(b) distribution options have tremendous variation. Make sure the options offered by the plan are acceptable to you.
Third, look at the investments. Just like with a 401(k), you want to see broadly-diversified, low-cost, index mutual funds in the plan. If all of the investments in the plan are expensive (more than one percent expense ratios) actively managed funds, you may not want to leave your money there for years, much less decades. The funds don’t all have to be good, but there have to be enough good ones for the account to be useable for you in your overall investing plan.
Finally, check out the fees. Despite an increasing number of lawsuits against employers for ducking their fiduciary duty to their employees, many still offer terrible retirement plans. Terrible plans have lousy investments and high fees. Ideally, the employer is paying all of the fees associated with the plan, but as long as the fees total less than one percent per year, the plan is probably still worth using.
457(b) plans can be a great addition to your retirement account quiver. However, before you start using one, you need to understand how they work.
Dr. Dahle (@WCInvestor) is a blogger, best-selling author, and podcaster. He is not a licensed financial adviser, accountant, or attorney and recommends you consult with your own advisers prior to acting on any information you read here.
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