Introduction
When it comes to workplace retirement plans, the 401(k) and 403(b) are the most well-known options. These plans have become the standard for millions of workers in the private and non-profit sectors. However, there is another powerful, but often overlooked, retirement plan that is available to a specific group of dedicated public service employees. It is called the 457(b) plan.
The 457(b) is a deferred compensation plan designed for employees of state and local governments. This includes people in crucial roles like police officers, firefighters, and city administrators. It offers many of the same benefits as its more famous cousins, but it comes with a few unique and incredibly valuable features. This guide will clearly define what a 457(b) plan is. We will also explain who is eligible for one. In addition, we will highlight its special rules and compare it to other common retirement plans.
Defining the 457(b): A Deferred Compensation Plan
First, let’s establish a clear definition. A 457(b) plan is a tax-advantaged retirement savings plan. It is primarily available to employees of state and local public entities. Some high-level employees of certain non-profit organizations, like hospitals or charities, may also be offered a version of this plan. The plan’s name, like the 401(k) and 403(b), simply comes from its corresponding section in the U.S. tax code.
The core concept behind a 457(b) is “deferred compensation.” This means that an employee voluntarily agrees to defer, or postpone, receiving a portion of their salary. Instead of being paid that money in their regular paycheck today, the employer deposits it directly into the 457(b) investment account. The money can then grow on a tax-deferred basis until the employee leaves their job or retires. The primary users of these plans are public servants who dedicate their careers to our communities.
The Unique Power of a 457(b): Contribution Rules
A 457(b) plan has several features that make it a uniquely powerful savings tool, especially for those who are able to take full advantage of it.
Independent Contribution Limits
This is a major advantage for certain employees. The annual contribution limit for a 457(b) plan is separate from the limit for a 401(k) or 403(b) plan. Most people will only have access to one type of plan through their job. However, in some rare cases, an employee might be eligible for both a 403(b) and a 457(b). For example, a university professor (eligible for a 403(b)) might also do consulting work for the state government (eligible for a 457(b)). If this occurs, that employee can contribute the maximum amount to both plans. This allows for a massive amount of retirement savings in a single year.
Special Catch-Up Contributions
Like other plans, 457(b)s allow for a standard catch-up contribution for employees age 50 and over. However, they also have a unique “special 457(b) catch-up” provision. This rule allows an employee who is within the last three years before their plan’s normal retirement age to contribute up to double the normal employee limit for those years. To be eligible, the employee must not have contributed the maximum amount in prior years. This can be a powerful way to supercharge savings right before retirement.
The Superstar Feature: Penalty-Free Withdrawals
The single most valuable and unique feature of a governmental 457(b) plan is its flexible withdrawal rule. This is what truly sets it apart from every other defined contribution plan.
As we have discussed previously, most retirement plans, like a 401(k), 403(b), or an IRA, impose a 10% early withdrawal penalty. You must pay this penalty if you take money out before you reach age 59½. This rule is designed to discourage people from raiding their retirement savings for non-retirement purposes.
Governmental 457(b) plans have a game-changing exception to this rule. You can begin to take withdrawals from your 457(b) account without the 10% penalty as soon as you separate from service with that employer. This is true regardless of your age.
- For example, a firefighter who retires at age 50 after a long career can immediately start drawing from their 457(b) account penalty-free.
- A city administrator who leaves their job at age 45 to start a new career can also access their 457(b) funds without penalty.
It is very important to note that you will still have to pay ordinary income tax on any withdrawals from a traditional 457(b), just as you would with a traditional 401(k). The key benefit is specifically the avoidance of the 10% early withdrawal penalty. This makes the 457(b) an unparalleled tool for public servants who often have the ability to retire earlier than those in the private sector.
457(b) vs. 403(b) and 401(k)
To understand where the 457(b) fits, a quick comparison is helpful.
- Primary Similarity: All three plans offer the same core benefits. They allow for tax-deferred growth of investments and have similar employee contribution limits. Many also offer a Roth (post-tax) contribution option.
- Key Difference 1 (Eligibility): The main difference is who can use them. 401(k)s are for for-profit companies. 403(b)s are for public education and certain non-profits. 457(b)s are primarily for state and local government employees.
- Key Difference 2 (Withdrawal Rules): This is the most important distinction. The ability to take penalty-free withdrawals upon separation from service is unique to governmental 457(b) plans.
- Key Difference 3 (Rollovers): You can roll over money from a 457(b) plan into an IRA or another workplace plan, just like with a 401(k). However, it is crucial to understand that if you roll your 457(b) funds into a traditional IRA, you will lose the special penalty-free withdrawal benefit. The funds in the IRA will then be subject to the standard age 59½ rule.
Conclusion
In conclusion, the 457(b) plan is a specialized but incredibly valuable retirement savings tool. It is a deferred compensation plan that offers tax advantages that are very similar to a 401(k). However, it is specifically designed to serve the dedicated employees of our state and local governments.
While it may not be as well-known as other retirement plans, its standout feature makes it unique. The rule that allows for penalty-free withdrawals as soon as an employee leaves their job makes it an unparalleled tool for those who plan to retire before the traditional age of 59½. For the public servants who dedicate their careers to our communities, understanding and maximizing a 457(b) plan is an essential step. It provides them with a powerful and flexible path to building a well-deserved and secure retirement.