403(b) and 457 Plans
At Alto Financial Group, our agents and financial advisors specialize on retirement and life insurance planning for public employees. Many public employees are offered a 403(b) or 457 Plan at their workplace which is one of the best retirement income sources available. We can help guide you through the process of picking the right 403(b) or 457 plan as you work to balance your financial goals for tomorrow with your needs for today.
The different 403(b) and 457 plans can be confusing. We understand that. Our licensed agents and registered investment advisors have the knowledge and experience you need to answer your questions and provide a personalized analysis of your portfolio. Your best interests are our top priority, and our experts can help you analyze the specifics of the 403(b) or 457 plan options available to you.
What is a 403(b) Plan?
A 403(b) plan is typically offered to employees of private nonprofits and government workers, including public school employees. Like the 401(k), 403(b) plans are a type of defined-contribution plan that allows participants to shelter money on a tax-deferred basis for retirement.
When these plans were created in 1958, they could only invest in annuity contracts. So, they were known as tax-sheltered annuity (TSA) plans or tax-deferred annuity (TDA) plans. These plans are most commonly used by educational institutions. However, any entity that qualifies under IRS Section 501(c)(3) can adopt it.
Contribution and Deferral Limits
The contribution limits for 403(b) plans are now identical to those of 401(k) plans. All employee deferrals are made on a pretax basis and reduce the participant’s adjusted gross income accordingly. The annual contribution limit, which is also called the elective deferral, is $19,500 for 2020. In 2021, the threshold remains the same: $19,500. For 2020 and 2021, an additional catch-up contribution of $6,500 is allowed for workers age 50 and above.
Notably, 403(b) plans offer a special additional catch-up contribution provision known as the lifetime catch-up provision or 15-year rule. Employees who have at least 15 years of tenure are eligible for this provision, which allows for an extra $3,000 payment a year. However, this provision also has a lifetime employer-by-employer limit of $15,000.
Employers are allowed to make matching contributions, but the total contributions from employer and employee cannot exceed $57,000 for 2020 or $58,000 for 2021. After-tax contributions are allowed in some cases, and Roth contributions are also available for employers who opt for this feature. Like with 401(k) plans, employers are allowed to institute automatic 403(b) plan contributions for all workers, although they may opt-out of this at their discretion. Eligible participants may also qualify for the Retirement Saver’s Credit.
When calculating 403(b) contribution limits for an individual, the IRS applies them in a specific order. First, they apply the elective deferral. The IRS then uses the 15-year service catch-up provision. Third, they apply the age 50 catch-up contribution.11 It is an employer’s responsibility to limit contributions to the correct amounts.
The rules for rolling over 403(b) plan balances have been loosened considerably over the past few years. Employees who leave their employers can now take their plans with them to another employer. They can roll their plans over into another 403(b), a 401(k), or another qualified plan. They can also choose to roll their plans over into a self-directed IRA instead. Employees can now maintain one retirement plan over their lifetimes instead of having to open a separate IRA account or leave their plan with their old employer.
Notably, 403(b) plan distributions resemble those of 401(k) plans in most respects:
- You can start taking distributions at age 59½, no matter if you’re still working at that organization or not.
- Distributions taken before age 59½ are subject to a 10% early-withdrawal penalty unless a special exception applies.
- All normal distributions are taxed as ordinary income.
- Roth distributions are tax-free. However, employees must either contribute to the plan or have a Roth IRA open for at least five years before being able to take tax-free distributions.
- Required minimum distributions (RMDs) must begin at age 72. The age for RMDs was 70½ until it was raised by the SECURE Act of 2019. Investors can avoid RMDs if they roll the plan into a Roth IRA or other Roth retirement plan. Failure to take a required minimum distribution will result in a 50% excise tax on the amount that should have been withdrawn.
- Loan provisions may also be available at the employer’s discretion. The rules for loans are also mostly the same as for 401(k) plans. Participants cannot access more than the lesser of $50,000 or half of their plan balance. Furthermore, any outstanding loan balance that is not repaid within five years is treated as a taxable or premature distribution.
Investment options in 403(b) plans are limited compared with other retirement plans. Funds can be invested into an annuity contract provided by an insurance company or invested into a mutual fund via a custodial account. Most plans now offer mutual fund choices as well, albeit inside a variable annuity contract in most cases. But fixed and variable contracts and mutual funds are the only types of investments permitted inside these plans.
What is a 457 Plan?
The 457 plan is a type of non-qualified, tax advantaged deferred-compensation retirement plan that is available for governmental and certain nongovernmental employers in the United States. The employer provides the plan and the employee defers compensation into it on a pretax or after-tax (Roth) basis.
A 457 plan has two types. A 457(b) is offered to state and local government employees, while a 457(f) is for top-level nonprofit executives.
For a 457(b) plan, you can contribute up to $19,500 in 2020 and 2021. You can also contribute an additional $6,500 in 2020 and 2021 if you’re age 50 or older. If you are within three years of normal retirement age, then you may contribute even more. You may be able to contribute as much as $39,000. However, your maximum contribution when you are within three years of normal retirement age is limited by previous contributions. This limit is, according to the IRS, “The basic annual limit plus the amount of the basic limit not used in prior years (only allowed if not using age 50 or over catch-up contributions).
The 457(f) plan is significantly different from its 457(b) counterpart. They are often described as “golden handcuffs” because retirement benefits are tied to a duration of service and other performance metrics. The 457(f) plan is primarily used to recruit executives from the private sector. Under 457(f) plans, compensation is deferred from taxation. However, this deferred compensation must be subject to a “substantial risk of forfeiture,” which means the executive is at risk of losing the benefit if they fail to meet the service duration or performance requirements. When the compensation becomes guaranteed and therefore is no longer subject to risk of forfeiture, it becomes taxable as gross income.
Unless you become the head of a nonprofit organization, you’re unlikely to run into the 457(f) plan. Because the deferred compensation is not yet paid and sheltered from taxation, the benefits remain in the hands of the employer. Rules require that executives must perform services for at least two years in order to receive benefits under a 457(f) plan. If you have a 457(f) plan, there is no limit on how much income can be deferred from taxation. However, amounts deferred are subject to a substantial risk of forfeiture.
Pros & Cons of the 457 Plan
- One of the better benefits of the 457(b) is it allows participants to double their retirement plan contributions if they are within three years of normal retirement age. Under this scenario, you may contribute up to $39,000 in 2020.
- You can also put in an extra $6,500 per year in 2021 if you’re at least 50 years old.
- While other plans do not allow distributions until you are 59½ years old, your 457(b) benefits become available when you no longer work for the employer providing the 457(b) plan. Otherwise, distributions are permitted when you are 70½ years old, or if needed for an unforeseeable emergency.
- If you leave your job, you can also roll over your account into an IRA or 401(k). However, this is only an option for the 457(b) plan, not the 457(f) plan.7
- Unlike the 401(k), the match your employer contributes will count as part of your maximum contribution. If your employer contributed $9,500 in 2020, then you can only contribute $10,000 (unless you’re participating in a catch-up strategy).
- If you’re used to a 401(k), you might already be aware that the $19,500 limit for 2021 applies only to employee contributions. For 401(k) plans, the total contribution limit, including catch-up contributions, is $63,500 for 2020 and $64,500 for 2021.
- It should be noted that few governments provide matching programs within the 457(b) plan. It’s mostly up to the employees to make sure they’re saving an adequate amount.
- The 457(f) plan requires that the employee works for a minimum of two years. If the employee leaves before that date, they forfeit their right to the 457(f) plan.
Advantages of a 403(b) or 457 Plan
- The earnings and returns on funds invested in a regular 403(b) or 457 retirement plan are tax-deferred until a withdrawal is made. You are still subject to the 10% penalty if you begin withdrawing from your retirement before reaching the age of 59 and a 1/2.
- 403(b) plans for teachers tend to have shorter vesting schedules than 401(k) plans. This means the money in the account is yours sooner.
- 403(b) plans for teachers have the same maximum contribution limit as a 401(k), but there is an exception to that—if you have served 15 or more years in your current position, you can contribute an additional $3,000 annually.
- Teachers with 403(b) plans are potentially eligible for matching contributions made by their employer. This option may not be available for every employee, and the amount can vary from employer to employer.
Take Retirement Into Your Own Hands
It can be easy to get bogged down in the complexity of choosing between plans and making the most out of your retirement savings. We can help guide you through choosing the right plan for you, counsel you on your salary contributions to that plan, and provide you with advice to help you achieve your financial goals.
The information contained herein is for informational purposes only and should not be considered investment or tax advice. For a personalized evaluation, please speak with your licensed agent or registered representative.