What is a 457 Plan?
Named for Section 457 of the Tax Code, this plan a type of non-qualified deferred compensation which can be available to state and local public employees, as well as upper management of non-church controlled tax-exempt organizations. They are similar to qualified plans in that deferrals are done on a pre-tax basis, and any growth in the account is not taxed until it is ultimately withdrawn, and then at ordinary income tax rates.
The limits for employee to defer salary into the 457 are the same as for 401Ks and 403bs: up to 100% of compensation, capped at $18,000 in 2016.
There is no co-ordination with deferrals between your 401K and your 457, meaning you have two separate and unrelated limits: You can defer $18,000 to both. There are two catch-up provisions, whereby an employee over age 50 can make contributions over the $18,000 limit:
- A special catch-up provision applies only to the 3 years before the employee’s normal retirement age (i.e. social security retirement age). The limit is increased to the lesser of: (a) twice the normal limit; (b) the normal limit plus the difference between the normal limit and the actual amount deferred in the previous 3 years.
- Participants in a governmental 457 have a flat catch-up amount of $6000 once they are age 50, making total deferrals . Only the greater of the special catch up or $6000 may be used in the 3 years preceding normal retirement age.
Consider this scenario: you have two jobs. You are self-employed and sponsor a 401K at your workplace. You are also a director of a non-profit, and as such are able to defer into the non-profit’s 457. Taken together, you can defer $36,000 This year. If you are over age 50, you can defer an additional $6000 into your 401K but not the non-governmental 457.
Where do we see 457 plans in use? Largely for public employees. The State of Florida sponsors a 457, as do Miami Dade County and the City of Miami. The underlying investments are a universe of mutual fund subaccounts, so the participant is exposed to market risk as in any defined contribution plan.
The rules regarding what you can do with your account upon separation from your employer’s service differ between the governmental and non-governmental 457. For the former you can distribute your account or consolidate it with other retirement funds in your IRA. At age 70 ½ the required minimum distribution rules apply. The non-governmental 457 can only be distributed, however. That fact makes a planner want to think two or three times before recommending a client participate heavily, in that the distribution could run the taxpayer up into the highest brackets in the year of the distribution, and wipe out 40% of the savings advantage!
A huge difference between 457 distributions and qualified plan and IRA distributions occurs before age 59 ½: there is no 10% penalty. If you are, say, 55 and want to retire early and live off of monthly distributions from your IRA: bad plan! every withdrawal will be subject not only to ordinary income tax, but also to a 10% penalty on the amount withdrawn. This penalty goes away at age 59 ½. There is no such penalty with a 457 plan, however. This is a particularly salient point for those public sector employees planning for an early retirement.
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