457(b) Deferred Compensation Plan

What Is a 457(b) Deferred Compensation Plan?

A 457(b) deferred compensation plan is a type of retirement savings plan available to certain employees, primarily those working for state and local governments and some nonprofit organizations. This plan allows participants to save and invest a portion of their pay before taxes are taken out. As a result, the taxable income is reduced for the year the contribution is made, and the funds grow tax-deferred until they are withdrawn.

Key Features of the 457(b) Plan

Eligibility

The 457(b) plan is designed for employees of state and local governments, as well as eligible nonprofit organizations. Some independent contractors may qualify to participate depending on their organization’s specific plan provisions.

Contribution Limits

For 2023, the typical contribution limit for a 457(b) plan is $22,500. Beneficially, individuals aged 50 and over can make additional catch-up contributions of $7,500, raising their total potential contribution to $30,000. Furthermore, unique to 457(b) plans is a special catch-up provision that permits participants to make higher contributions for up to three years before the normal retirement age, if they haven’t contributed the maximum amount in previous years.

Tax Advantages

The primary benefit of a 457(b) deferred compensation plan is its tax-deferral feature. Contributions are made on a pre-tax basis, reducing an employee’s taxable income in the year contributions are made. Additionally, the investments grow tax-deferred, meaning taxes are only due upon withdrawal, typically during retirement when the participant may be in a lower tax bracket.

Distribution Rules

Withdrawals from a 457(b) plan are taxed as ordinary income. Crucially, unlike 401(k) and 403(b) plans, 457(b) plans do not impose a 10% early withdrawal penalty for withdrawals made before the age of 59½. This feature provides participants with more flexibility in accessing their funds. However, specific plans may have restrictions and timelines that govern when and how withdrawals can be made.

Differences Between 457(b), 401(k), and 403(b) Plans

Here's a table that summarizes the differences between 457(b), 401(k), and 403(b) plans to highlight their unique characteristics:

Investment Options and Strategy

Participants in a 457(b) plan typically have various investment options similar to other retirement plans. These options often include mutual funds, target-date funds, and sometimes individual stocks or bonds, depending on the plan sponsor's offerings.

Diversification and Risk Management

To manage risk effectively, 457(b) participants should consider diversifying their investments across different asset classes. For example:

• Equities: Stocks can offer significant growth potential over time, albeit with increased risk.
• Bonds: These provide more stability and income, reducing portfolio volatility.
• Cash or Money Market Funds: While offering limited growth potential, these options are the safest, providing liquidity and preserving capital.

Target-Date Funds

Many participants choose target-date funds due to their simplicity. These funds automatically adjust the investment mix based on the anticipated retirement date, becoming more conservative as retirement nears. This approach can suit individuals who prefer a hands-off investment strategy.

Advantages and Disadvantages

Advantages

• Flexibility in Withdrawal: The absence of a penalty for early withdrawals can be advantageous for employees who may need access to funds before reaching retirement age.
• Double Contributions: In some scenarios, employees might contribute to both 401(k) and 457(b) plans, potentially maximizing their tax-deferred saving space far beyond traditional limits.
• Tax Benefits: Contributions reduce taxable income, and taxes on growth are deferred until distribution.

Disadvantages

• Limited Availability: Not all employers offer 457(b) plans, limiting access to eligible employees.
• Possibility of Lower Employer Contributions: Unlike some 401(k) plans, employer matching is often less common or limited with 457(b) plans.

Common Questions and Misconceptions

Can I Roll Over a 457(b) Plan?

Yes, funds from a 457(b) plan can typically be rolled over into other eligible retirement accounts such as an IRA, 401(k), or another 457(b) plan upon separation from service. This conserves the tax-deferred status of the funds.

What Happens to My 457(b) Plan if I Change Jobs?

If you leave your current employment, you have several options for handling your 457(b) plan:

• Leave your funds in the existing plan if allowed.
• Roll over the funds into a new employer’s 457(b) or other retirement plan.
• Transfer the funds into an Individual Retirement Account (IRA).

Are There Roth Options in a 457(b) Plan?

Some 457(b) plans do offer a Roth option, allowing participants to make after-tax contributions. While they don’t reduce taxable income in the year of contribution, qualified withdrawals (after five years and reaching age 59½) are tax-free.

Recommendations for Further Reading

To gain a deeper understanding of 457(b) plans and other retirement options, consider exploring resources provided by reputable financial advisory firms or the IRS. Broader retirement planning insights can also be gleaned from organizations such as the Financial Planning Association.

In summary, the 457(b) deferred compensation plan is a flexible and beneficial savings tool for eligible employees seeking to bolster their retirement savings with tax advantages. By understanding its features and strategizing investments wisely, participants can make the most of this financial vehicle. Whether you’re new to retirement planning or seeking to optimize your savings, exploring your options thoroughly and consulting with financial professionals can enhance your financial well-being as you prepare for retirement.