Should I invest in my 457? The What, Why, and When

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?

Day at the beach
Whether you invest in a 457 or not isn’t quite as simple as choosing a beach front vacation. A little more thought is involved.

[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?

Earnest

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.

Gunslinger
Unless you are a gunslinger by nature, you should pause before participating in a non-governmental 457.

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.

Take Home

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?

TPP

20 thoughts on “Should I invest in my 457? The What, Why, and When

  1. Hi TPP! This is a great review of 457’s and the distinction between the governmental and non-governmental variety.

    I would also like to note the potential advantage of withdrawing from your 457 account penalty free (unlike 401k or 403b) if a person separates from their employer early. This could be useful for early retirees who want to access their money before 59 1/2.

    And I totally agree with you… if you have a governmental 457 available, it’s a no brainer… do it! Just like you, my wife contributes to her governmental 457 (she’s a state prosecutor). Between maxing out this account and her 401k, it’s allowed us to save a lot for retirement (and shelter a lot from taxes). In fact, her entire paycheck earlier this year (pre-maternity leave) was used to fund both accounts so we will be minimally taxed on her income :).

  2. I went back and forth, literally, in the past 5 years. Some years I did and some I didn’t contribute to my non-govt 457. I am privy to the financials and we are super solvent so I’m not worried. However, I’m leaving this year and will need to take a distribution, leave it or take it over 5-10 years. My new employer has non-govt 457 but doesn’t accept transfers.

    It’s got about 36K so I’m just gonna take the lump sum next year. Taking over 10 years makes more sense financially but I don’t want to keep track of it over 10 years. I’ll take the tax hit 2018. I’m going down a bracket with the new code and new job so it’s not terrible.

    In retrospect I would not have contributed. They plans are not transparent and the rollover options are unknown until new employment is secured. However, if I retire early the 456 is the first money to take. As I might RE, I will be doing another 457 next job. Tax tail wagging? Maybe… but my bracket is soooo high I can’t help myself.

    • Yeah, that’s exactly what I plan to do with my 457. Use it to bridge the gap to 59.5 when I can use my 403B. Have a post coming up on bridging this gap.

      It is tough to decide because no one knows what the future holds. Will you change employers? Will your employer’s financial situation change?

      Like poker (and life) you just have to make the best decision you can with the information you have at the time. You can’t judge your result based on the result.

  3. I’m now maxing out my governmental 457, as a State govt employee. The tax benefits have been great, and it allows me to painlessly saved 30%+ of my income straight off the top. The biggest benefit is the ability to access the money penalty-free before 59.5, since many government employees are retired from service long before that age (police and fire, especially). I wish I could roll it over to Vanguard but I don’t see where they host 457 plans, so I’ll keep it with Voya.

    • It’s great that you can roll it over at all since it’s a governmental. My non-governmental 457 is not allowed to do that.

      Have you looked to see if other big companies outside of Vanguard (Fidelity, Schwab, etc) allow 457 roll overs?

      I, too, love the fact that you can access it in early retirement without getting hit with the 10% penalty.

      • Well I haven’t researched it much at all because my plan does not allow in-service withdrawals or rollovers, but I am separating from service to take a new job soon (within a few weeks!) so I will be looking into it more very soon. I literally just got the offer between posting the earlier message and your reply 5 minutes later 🙂

  4. I would also add pausing if the investment options are just terrible. Its been a while since I’ve looked at a 457, but sometimes they are provided to governmental entities by insurance companies, causing some high all-in fees that can eat away at what were your up front tax savings. Its not always a good idea to invest in every tax free plan available.

  5. A couple of questions I’ve had a hard time finding answers to:
    1) What if your company is bought out by another company and the acquiring company doesn’t have a 457 or decides not to continue it?
    2) I’ve asked our HR person about timing of distributions if I leave the company and she replied that I can choose the distributions to start at any date, not necessarily the date I leave the company. But this seems to run counter to this article. What’s the right answer? Is it plan-dependent?

    • 1) not sure about this one, but given that your 457 was being run by a company of some kind (TIAA, Transamerica, etc) I imagine you’d have similar options to when you left the employer. Otherwise it might be plan dependent.

      2)I think it is plan dependent. I do know that some employer’s will let you keep your money in the 457. This would not be appealing to me as I would be pretty far away from what is happening there after I leave. I would want to take the money a
      s soon as possible while minimizing my tax burden. The entire time it is there it is available to creditors.

  6. Nice post! It was interesting to see the comparison as well as what to watch out for with non-governmental 457 plans.

    I have a government 457 plan, and I’m currently in year 2 of maxing it out. I’m in the over 50 group that didn’t contribute enough in the past. Being able to now put in $37,000 per year is fantastic!

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