What is a 457 Plan
A 457 plan is a defined contribution plan offered to state and local government employees, as well as employees of tax-exempt organizations. Just like its counterpart, the 401(k) that is available for private sector workers, the 457 is a deferred compensation plan that participants contribute to with pretax dollars. The contributions and all of the earnings retained within the account grow untaxed until distributions begin after age 59 ½. The assumption is that the account owner will be in a lower tax bracket once distributions begin after retirement.
Even if the account owner is not in a lower tax bracket, the benefits of a 457 plan include a reduction in current taxable income, tax-deferred earnings, dollar cost averaging through payroll deductions, the ability to take your account with you if you leave your job, and no penalty for early withdrawals. (The exception to this is the 457(f), which is discussed later.) Further, the contribution limits for 457 plans are much higher than those for traditional and Roth IRAs.
Organizations eligible to establish 457 plans include but are not limited to those that provide educational services, non-profit organizations, hospitals and medical centers, charitable foundations, unions, certain trade associations, and electric co-ops that are tax-exempt and non-rural. State and local governments, including smaller municipalities, along with organizations that are funded solely by the state are also usually eligible for 457 plans.
While investment options vary by employer, most 457 plans offer a wide range of investment choices. Equity funds will typically range from large cap to small cap, index, to growth. Bond funds will normally range from fixed income to variable. By offering a wide variety of funds, employees of any age will be able to select investments that are appropriate for their needs. For example, older employees may be more heavily concentrated in bond funds whereas younger employees may want to focus exclusively on highly aggressive stock funds.
Choosing the right balance of asset allocation is as important in a 457 plan as it is with any other kind of employer-sponsored retirement plan. Each employee should ensure that the funds selected are suitable for his or her financial goals. Those who have access to a 457 plan are always advised to contribute as much as they comfortably can in order to maximize their retirement savings.
Contribution Limits for 457 Plans
When the 457 plan is the only retirement savings plan offered by the employer, the 2011 contribution limit is $16,500 (or 100% of compensation, whichever is less) for those under 50 years of age. For those who will turn 50 by the end of the year, the limit is $22,000. Those who are within three years of retirement and have under contributed to the plan in previous years are eligible for the double limit catch-up, which is an additional $16,500.
If an employer offers a 401(k) or 403(b) plan along with the 457 plan, the employee can contribute the maximum amount to both plans. This provides a huge retirement savings benefit to public and tax-exempt sector employees who traditionally are paid much less than their private sector counterparts. Most of the changes to these plans occurred in 2001 as part of revised tax legislation.
No Early Withdrawal Penalties for 457 Plans
Unlike private sector 401(k) plans, traditional IRAs, and Roth IRAs in which up to a 25% penalty can be levied against an early withdrawal, there are no early distribution penalties charged against a 457 plan. If the distribution is taken prior to age 59 ½, the account owner must pay income tax on the distribution, but does not pay the penalty. However, distributions must begin by age 70 ½ for those who participate in 457(b) plans. The mandatory distribution age does not apply to 457(f) plans.
Non-Governmental 457(b) Plans
The non-governmental 457(b) plan is limited primarily to employees who receive higher compensation. For the most part, these employees are officers, directors, and other high-level workers. This presents a tremendous opportunity for these employees to defer federal and state taxes while saving for retirement.
One restriction of the non-governmental 457(b) plan is that the account cannot be rolled over into another kind of tax-deferred retirement savings account. It can only be rolled over into another non-governmental 457 employer-sponsored plan. This is much different than a 401(k), in which the account owner can rollover the account into a traditional or Roth IRA, or another employer-sponsored plan if he or she leaves the company. Money that is placed into a 457(b) is not held in a trust account for the employee. It remains the property of the employer, not the employee. Therefore, the account is subject to seizure by creditors and losses. This is also significantly different than a 401(k) and other employer-sponsored retirement savings plan. With a 401(k), the employee is always 100% vested in his or her own contributions. While the employer may have a vesting schedule that vests the employee in employer contributions over a period of several years, the money is held in an account. The employer must keep employee money separate from general business and other accounts.
457(f) plans are normally used to compensate a highly paid employee of tax-exempt or 501(c)(3) organizations. The contributions provided through this plan are non-qualified and are not paid to the employee until retirement. The assets belong to the organization until they are paid to the employee, which means the employee has the benefit of deferred compensation without a current tax liability. The amount that can be contributed to a 457(f) plan is unlimited.
Contributions to a 457(f) plan can be invested in annuities and mutual funds, but always remain the property of the employer until distributions begin. In other words, these plans create a tax shelter for employee by sheltering compensation from taxes. Since the employee does not take ownership of the assets, he or she can defer the income tax for as long as the employer owns them.
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