Employees of cities, counties, water districts, or other similar municipal entities often have access to a special type of retirement plan through their employers. Called governmental 457 deferred compensation plans (often shortened to 457 plans), these programs allow employees to make contributions from their paychecks which are then invested in programs chosen by the employees. These plans are only available to state and local government employees, not federal employees.
Another type of 457 plan, called non-governmental 457 or “top hat” plans, can only be established by certain tax-exempt entities for the benefit of groups of highly-compensated employees (HCEs) or groups of executives, officers, directors, or officers. The top hat plans can’t be offered to regular employees.
Generally speaking, 457 plans are very similar to better-known retirement plans, like 401(k) plans or 403(b) plans. There are, however, some important distinctions. One is that 457 plans don’t have to be offered to all employees, as noted above. They are considered “non-qualified” plans, and are governed by different rules than 401(k) or 403(b) plans are.
The fundamentals of 457s
Just like 401(k)s, 457 plans allow participating workers to set aside part of their paychecks into a tax-deferred savings plan that offers a range of investment choices. Any contributions grow tax-deferred until retirement, and when they’re withdrawn, they’re subject to income taxes.
457 plans have the same contribution limits as 401(k) and 43(b) plans ($18,000 for 2015). Some plan participants, though, may have the choice of contributing to either a 457 plan, or a 401(k) or 403(b). In fact, they can even contribute to both at once. If that’s the case, those participants can contribute the maximum amount to BOTH plans (totaling $36,000 in 2015).
In addition, 457 plans have the standard catch-up provision of 401(k)s and 403(b)s, where employees aged 50 and older can contribute additional funds to the plan ($6,000 for 2015).
One difference is that 457 plans can provide a special catch-up contribution feature. Employers aren’t required to allow it, and the formula is complex. In the three years prior to his or her retirement, a 457 participant can contribute the lesser of twice the annual limit OR the annual limit, plus the amount of the basic limit not used in previous years.
Another key difference is that 457 participants can take distributions as soon as they leave their employer, regardless of their age. There’s no early withdrawal penalty for 457 plans, though withdrawals are taxed as income. This benefits certain professions like police and firefighters, who may leave their employment before age 59½.
There are two types of 457 plans, which include 457(b) (which are “eligible”) and 457(f) (which are “ineligible”). They’re divided into two categories: government and nongovernment. Government 457(b) plans are the most common type. However, certain tax-exempt employers can establish ineligible 457(f) plans, but they can only be offered to highly compensated employees. They’re often called “top hat” plans, and they help those highly compensated employees save more money for retirement. Top hat plans are exempt from many ERISA requirements.
What are the advantages of a 457 plan?
These plans offer many of the same benefits that qualified plans provide, including:
- Tax-deferred contributions, so any of your contributions and earnings are free of income tax until withdrawal.
- Earnings on the funds are also tax-deferred.
- You can select from a range of investment options chosen by the plan sponsor.
- Your employer may choose to provide matching contributions, which will help you build your retirement savings.
- Participants age 50 and older can make “catch-up” contributions (up to $6,000 in 2016).
However, 457 plans are not exactly like other retirement plans. There are some other elements of these plans that separate them from other qualified retirement plans, such as:
- Money can be withdrawn before age 59 ½ without a 10 percent penalty, as long as the participant is retiring or ending his or her employment. The participant will still owe regular income taxes on the withdrawal.
- Employees who have both 457(b) plans and 401(k) or 403(b) plans can contribute the maximum allowable to both plans. For 2018, that amount is $18,500, which means participants in two plans can contribute a total of $37,000.
- Some plans allow special catch-up contributions. For three years prior to the normal retirement age specified in the plan, these participants can contribute up to twice the annual limit.
Talk to the Experts
457 plans must follow very specific rules and regulations. For example, government 457 plans must hold all plan assets and income in trust, or in custodial or annuity accounts for the exclusive benefit of participants and their beneficiaries. Non-governmental “top hat” 457 plans must hold all plan assets as property of the employer, which means they can be seized by creditors if the company goes into default. At FiduciaryFirst, we’re experienced with all types of retirement plans, including 457 plans. Contact us at 1-866-625-4611 for more information.
Some employees of state and local governments, along with some employees of tax-exempt organizations, may have access to a particular type of retirement plan called a 457 plan. Originally, 457 plans (named after the portion of the tax code that created them) were very unique in their rules. However, in 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) made significant changes to 457 plans, and now they’re much closer to 401(k) and 403(b) plans. However, there are still some differences.