When saving for retirement, your employer may give you a hand by offering a tax-advantaged savings plan. Your options might include a 401(k) plan or a 457(b) plan. Both plans allow you to contribute money towards retirement on a tax-deferred basis. While there are similarities between a 457(b) and a 401(k), there are also key differences to keep in mind. Those variations can affect how a plan will work for you and your retirement.
What Is a 457(b) Plan and How Does It Work?
A 457(b) plan is a non-qualified, deferred compensation plan. It typically is offered to state and local government employees, as well as employees of certain tax-exempt organizations. The kinds of employees who may have access to a 457(b) through their employer include:
In terms of how a 457(b) plan works, it’s very similar to a 401(k) when it comes to who makes contributions, how much they can contribute and the tax treatment of those contributions. For 2019, workers with a 457(b) plan can contribute up to $19,000 to their account through elective salary deferrals. Workers age 50 or older can add $6,000 in catch-up contributions, bringing the total annual contribution to $25,000.
This money grows tax-deferred meaning no taxes are owed on investment earnings until money is withdrawn. An employer can designate a 457 account as a Roth account with after-tax contribution. Those contributions wouldn’t be deductible from taxable income, the way they would with a traditional 457(b). But employees would benefit from tax-free distributions in retirement.Special Rules for 457(b) Plans
Two attributes make these accounts different from 401(k) plans. First, employer matching contributions are typically less common with 457(b) plans. If an employer makes a matching contribution, those contributions plus the employee’s can’t exceed the total annual contribution limit. If your employer contributes $5,000 to your plan for 2019, your contribution limit is $14,000 for the year. That only changes if you’re 50 or older.
Also, 457(b) accounts allow for special catch-up contributions for workers three years away from normal retirement age. Those employees can contribute the lesser of twice the annual contribution limit (which would be $38,000 total for 2019) or the regular annual limit, plus the amount of the annual contribution limit not used in prior years. The latter is allowed only if the employee isn’t using the standard 50-or-older catch-up contributions.What Is a 401(k) Plan and How Does It Work?
A 401(k) is the most popular type of qualified retirement plan offered by employers. Any company can offer one of these plans to their employees, including government and non-government organizations. The annual contribution limits for 401(k) plans are identical to those allowed for 457(b) plans.
However, it’s more common for employers to make matching contributions to these accounts. With a 401(k) match, the employer can determine what percentage of employees’ income to match. They’re not restricted by the annual contribution limit.
A traditional 401(k) grows tax-deferred, with withdrawals taxed at your ordinary tax rate in retirement. Some employers offer a Roth 401(k) option. The biggest catch of these plans is a 10% penalty for early withdrawals, on top of regular income tax.
Your plan may allow for loans, and the limits for borrowing are the same as 457(b) plans. With either plan, failure to repay the loan in full means the amount becomes a taxable distribution. The difference is that if you’re under age 59.5 at the time of the distribution, you’d only pay the 10% early withdrawal penalty if the money comes from your 401(k).Pros and Cons of Saving In a 457(b)
One of the main advantages of saving in this type of account is that it’s a non-qualified plan. This means that it’s not subject to the same withdrawal rules as a 401(k).
They aren’t technically retirement plans and don’t come with early withdrawals penalties. In other words, you can take money from your account at any time. Withdrawls prior to or after retirement don’t trigger a penalty based on age. You would, however, pay regular income tax on those withdrawals, unless you have a designated Roth account. That means more flexibility if you need money for an emergency, to pay for college expenses or to buy a home.
You can make a withdrawal and pay taxes on the amount withdrawn or avoid paying taxes by taking a loan instead, if your plan administrator allows it. Assuming you’re eligible to borrow from your 457 plan, you’d be able to take the lesser of $50,000 or 50% of your vested account balance. You’d then repay that money, with interest, typically over a five-year period. However, you may be able to extend repayment longer if you’re using the money to buy a home.
Conversely, 457(b) plans may charge higher administrative and management fees than other types of workplace retirement plans. You may have a more limited range of investment options to choose from within the plan as well. That could be a challenge to your diversification strategy.Pros and Cons of 401(k) Plans
These plans allow more leeway when it comes to employer matching contributions. That’s great if you’re funneling a big chunk of your income into your account each year. A 401(k) may also carry fewer fees compared to a 457(b) plan, and have a wider range of investments to choose from.
Some drawbacks to 401(k)s include the fees and investment choices linked to individual plans. Some plans, for instance, may charge more in administrative fees and cut into returns. Or, your plan may not offer the investments you’re interested in adding to your portfolio.457(b) vs. 401(k)
It’s possible that you may have access to a 457(b) and a 401(k). The IRS says it’s okay to contribute to both at the same time.
Since retirement plans typically have contribution limits, contributing to a different plan can double your tax deferral.
But in which order you should fund your accounts? If you’re under 59.5, then it might make sense to max out your annual 457(b) contribution first. That way, if you need to withdraw money for any reason, you could tap into that account without triggering an early withdrawal penalty. On the other hand, if you’re over age 59.5, you may want to fund the account that offers the highest employer matching contribution first to take advantage of that free money.Bottom Line
Both a 457(b) and a 401(k) can help you grow retirement savings for the long term. Understanding how both plans work can help you make the most of your contributions during your working years.
Meanwhile, government employees may be able to double up their savings. It all depends whether or not an employer includes both plans as retirement savings options.Retirement Savings Tips
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