Should I invest in my 457 deferred compensation plan? That’s a tough question. It’s just not the same as answering whether or not you should invest in your 403(b) or 401K. That’s much more straight-forward. Today, we will discuss the 457 deferred compensation plan. Today’s post will answer the question, “Should I invest in my 457?”
What is a 457?
[I realize this may be too basic for some of the readers on this site, but I think it’s important to explain what a 457 is and what it does. It’ll only take a second.]
Just like any other retirement plan with numbers, this comes from the part of the IRS tax code (section 457) for deferred compensation plans. It is a “deferred compensation plan” that allows you to make pre-tax contributions and will allow your earnings to grow tax-free while in place.
There is an important distinction, and I am going to make it early. There are two ways you can qualify for a 457. You work for the governmental (governmental 457) or you work for a 501(c)3 non-profit organization (non-governmental 457). The governmental and non-governmental 457’s have some similarities and some very important differences.
The following are some details that are similar to both:
Applies to all 457s
Contribution limits for 457 plans are $18,500 for most of us. For some over the age of 50, you may be able to contribute more (possibly as much as $37,000 if within three years of retirement age for your plan). Also read below regarding > 50 year old catch-up contributions.
All 457’s may be transferred from one 457 to another (governmental to governmental; non-governmental to non-governmental). However, the receiving plan must accept transfers.
You must take payments by April 1st following year of retirement or age 70.5 years old (whichever happens later).
Governmental 457s versus non-governmental 457s (Reference IRS publication)
- May be rolled over to eligible retirement plans (non-governmental: rollovers not permitted)
- Age > 50 catch-up contributions are only available for governmental 457s.
- Non-governmental (“Top-Hat”) plans must limit the number of people who can participate to ” groups of highly compensated employees or groups of executives, managers, directors or officers.”
- Governmental 457’s often allow Roth contributions. Non-governmental 457’s do not allow Roth contributions…otherwise this would be a great way to avoid the possible tax consequences of bad distribution options.
- This is the most important difference: Governmental 457s are backed by the US government (non-governmental: backed by individual institution and available to creditor’s upon legal action or bankruptcy). This is the exact wording from the IRS on non-governmental 457s:
“[Non-governmental]Plan assets are not held in trust for employees, but remain the property of the employer (available to its general creditors in the event of litigation or bankruptcy)….Employees are lower in priority than general creditors in the event of legal claims against the employer.”
What this last bullet point means is that if your institution goes bankrupt or into major litigation, your hard-earned retirement money is available to creditors. I’ll have to do another post sometime on cases where this has happened, but it has definitely happened.
Also, this is very different from your typical 401K or 403B which is protected even in the case of most personal litigation (i.e. medical malpractice cases).
Why should you consider investing in a 457?
There are certainly tax benefits associated with participating in a 457. This includes being able to contribute pre-tax money to decrease your overall tax burden. The gains also grow tax-free. Your only taxation occurs when you take it out. This all sounds exactly like your standard (pre-tax) contributions to a 401K and 457.
If you have a governmental-457, this is backed by the government. If the government defaults, we are all in trouble. The market would likely crash. This provides some comfort for those with a governmental 457. In fact, I would argue that you could view a governmental 457 as a second 401K or 403B. It’s just as safe and provides many of the same benefits. Congrats, if you have one!
For example, my wife is a teacher in a public school. Actually, she is a part-time teacher. So, while she does not have access to a 401K/403B as a part-time worker, she does have access to a governmental 457. This is great for us, because she basically earns the contribution limit at her job (right around $20,000). So, we contribute almost $18,500 to her 457 and basically pay no tax on her income because it all goes in there. When she goes full time, we will contribute more to her 403B.
Why you should pause before contributing to a non-governmental 457
The differences between a governmental and a non-governmental 457 may seem small, but nothing could be less true. There is a massive difference. I mentioned many of them above, but here is why they should give you pause.
Big Difference Number 1
Your money is available to creditors. Combine this with the fact that most of us do not have inside information on our employer’s financial situation. That makes for an uncomfortable and sleepless situation. If you don’t think your employer can close up shop, ask physician on fire. If you aren’t intimately familiar with how secure your employer is, I’d caution you in participating in your non-governmental 457.
Big Difference Number 2
The distribution options are often terrible. You cannot contribute via Roth to non-governmental 457s. Therefore, you are likely to foot a huge tax bill if you leave your employer unless your new employer accepts transfers (not so common).
Many 457 distribution plans require you to take the lump sum upon leaving. That’s a huge loss to taxes. Some plans have better distribution options, but you should ask for the 457 plan details before you contribute. If they don’t let you take it out over a 5 to 10 year period, it may not be worth it.
Big Difference Number 3
Lest you think you’d avoid the problems with a non-governmental 457 via Roth contributions (nope), you might think about rolling it into a retirement account after you leave. Unfortunately, you can’t do that. Again, you are left with less options with a non-governmental 457.
When should you participate in a 457?
If you have a governmental 457
The answer is easy. If you have the income, then you should participate. It’s essentially an extra 401K/403B.
After you fill up your 401K/403B, the governmental 457 should be the next retirement space you fill up. If you have room after that, then a stealth (HSA) IRA and backdoor Roth IRA are your next bets. Then a taxable account. Governmental 457’s make life easy.
If you have a non-governmental 457
All of the following assumes that your 457 has good options in which to invest (i.e. low expense-ratio passively managed index funds).
The answer becomes more complicated. The one thing that I can tell you that no one would disagree with is that you should be intimately familiar with your employer’s 457 plan. Ask for it. They are required to give it to you by law.
Also, in my opinion, you should contribute to your 401K/403B, stealth (HSA) IRA, and backdoor Roth before you consider a non-governmental 457. Those offer better features at less risk. I don’t think this is as controversial as what I am about to say. Most would agree with this.
I would not participate in a non-governmental 457 unless I was satisfied with number 1 and number 2 above in the section above on what should give you “pause.” You must be very confident of your employer’s financial situation and stability. If you have any concerns, then don’t participate in your 457. A taxable account is a better option in this situation.
If you are okay with your institution’s financial situation and stability, then check the distribution options. If they don’t let you a) keep the money in or b) take the money over a period of years… then, again, I would hesitate to participate in that 457.
For those who plan to leave their current employer or plan to FIRE (retire early), the 457 is not a great option unless your distribution options are solid. That said, if they are good, then this may be a good way to fill the gap before age 59.5 when you can access your 401K/403B. More to come on this in an upcoming post in April 2018.
Therefore, if you have a governmental 457…get started, like yesterday.
If you have a governmental 457 it is my contention, that unless you know about the stability/financial situation of your employer and you have good investment choices and distribution options, a non-governmental 457 is a no-go.
My employer’s 457 does offer good options. We are choosing to spend extra money paying down debt for right now, but may consider participating in the 457 for the last 10-12 years prior to retirement. I have an upcoming post on why that is in a few weeks!
I realize this is a contentious topic. What are your thoughts? I’d love to hear them, particularly if you disagree with my assessment. Do you contribute to your non-governmental 457? If so, does it meet my criteria?