Although most teachers do not receive an employee match for their 403b contributions, they have another, arguably more beneficial tool that nobody seems to be talking about-the 457b plan.
Similar to the 403b, the 457b allows teachers to invest $19,500 in a tax advantaged account. When combined with a 403b, teachers have the opportunity to invest $39,000 per year, tax deferred!
That number grows even more for individuals over the age of 50.
This is a HUGE opportunity since teachers can effectively double down on their retirement savings.
Not only that, but the 457b has a powerful provision that allows individuals to access their funds at ANY AGE when they separate from their employer.
So for those on the path to Financial Independence who may be interested in retiring early some day, this plan is the HOLY GRAIL.
This post will focus on everything you need to know about the 457b plan.
Let’s jump in.
What is a 457b?
A 457b is a deferred compensation plan offered to employees of state and local governmental agencies.
Investment contributions to a 457b are automatically deducted pre-tax (traditional) or after tax (roth) from your paycheck, and grow tax-deferred in your investment account.
The employee assumes the investment risk and participation in the plan is self-directed and at the discretion of the employee.
What are the benefits of a 457b?
No Early Withdrawal Penalty Upon Separation of Service
Once you leave your employer you can withdraw your funds with NO 10% early withdrawal penalty. This is a major benefit for anyone that may consider retiring early. This rule only applies to a 457b, not a 403b, making a 457b plan more desirable for some.
Tax Benefits
In a traditional 457b, money you contribute is pre-tax. Pre-tax investing is valuable since it maximizes the amount of money you can contribute. Taxes are paid on your contributions and capital gains when you withdraw.
Also, traditional 457b contributions reduce your taxable income for the fiscal year that you contribute. So not only are you paying yourself first but you don’t have to pay as much in federal income tax at the end of year. That’s a HUGE win for you.
In a Roth 457b, money you contribute is after-tax. Income earned on the account is tax-free and withdrawals are not taxed. Contributions to a Roth 457b do not reduce your taxable income for the year you contribute.
Automatic Payroll Deductions
Contributions to a 457b are made directly from your paycheck. This is beneficial as you are automatically paying yourself first before you have the ability to spend. Additionally, automated investing helps to keep you accountable for sticking to your financial goals.
Additional Savings
A 457b can be a large contributor to your retirement savings. It can be combined with other retirement saving options (like a 403b and pension) to maximize your retirement nest egg.
If you have access to both a 403b and a 457b, that means you can DOUBLE the amount of money you contribute pre-tax. This puts teachers at a huge advantage. Almost all other jobs do not offer this much in pre-tax retirement savings.
What other things to keep in mind?
Contribution Limits
The max amount that you can contribute to a 457b plan is determined annually by the IRS.
In 2020, the contribution limits for a 457b is $19,500.
If you are above the age of 50, the annual contribution limit is $26,000.
Additionally, if you are within three years of your plans normal retirement age (specific to your type of plan), a catch up provision allows you to contribute the lesser of:
- Double the current years contribution. In 2020, that would mean a contribution of $39,000
- 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)
Withdrawal Rules
If you are staying with your employer, you cannot withdraw money from your 457b until you reach age 59.5
If you separate from your employer, you can withdraw funds with NO 10% early withdrawal penalty.
When you reach age 70.5 you are required to start withdrawing funds from your account.
Vendors
Your 457b plan can be chosen from a single or list of vendors provided by your employer.
Deciding which vendor you choose for your 457b plan will be determined by the type of investment product you want.
Different vendors offer an array of different investment products.
Products
Typically, the types of investment products offered within 457b’s are mutual funds and annuities.
A mutual fund is an investment vehicle that pools money from investors and invests in a grouping of stocks, bonds, or other assets.
There are two types of mutual funds: load mutual funds and no-load mutual funds. Loads are a commission or sales charge that is paid by you to the fund manager for their services.
Additionally, mutual funds can be actively managed or passively managed. Actively managed mutual funds have the goal of attempting to outperform the returns of the market but come with higher costs to the investor. Passively managed funds, such as index funds, simply try to generate the same returns of a given market index (such as the S&P 500). Passively managed funds have very low costs and fees because there is very little management involved.
Annuities are a contract between the employee and an insurance company where the employee makes regular payments to the insurance company in return for a lump-sum or series of disbursements immediately, or at time of retirement.
The most common types of annuities are fixed annuities and variable annuities. A fixed annuity is an insurance contract that promises a specific interest payment on contributions to the buyer. A variable annuity is an insurance contract that pays interest dependent on the performance of assets within the account. Most annuity products have very high fees.
What to be careful of?
Poor Vendor/Product Selection
Where you invest your 457b money is not entirely up to you. Employers provide a single vendor option or a list of vendor options, from which you can see each vendors list of investment products, and thus make a decision on where to allocate your 457b savings. In most cases the list of vendors and investment products is limited, and contain many poor options.
High Fee’s
Fee’s are the operating and administrative costs associated with a particular investment product. The fee’s from one product to another can vary greatly, and understanding the role that fee’s play is important. Fees, although they may appear small and insignificant, can have a MAJOR impact on returns.
Mutual fund products and variable annuities are required to outline their fee’s in a document called a prospectus. Fixed annuities do not have a prospectus, but rather a sales contract that outlines the fee’s associated with the product. Asking for these documents and reviewing them is important before investing your money.
For more on the impact of fee’s on your retirement investments check out my article on 403b’s.
Action Steps
Contact your employers payroll office to inquire about which 457b options are available to you.
I suggest going with a vendor that offers passively managed low-fee, no-load mutual funds such as an index fund.
Their performance is consistent over the long term and their costs are extremely low.
The Bottom Line
Contributing to a 457b can be a great primary or supplemental resource for long term investing.
Contributions are in addition or in place of a 403b plan. If you have access to good investment options in both your 457b and 403b, consider contributing to both accounts.
If you separate from your employer, you can withdraw funds with NO 10% early withdrawal penalty.
Avoid vendors and investment product with high fees and poor product selection.
Do your own homework and ask questions before choosing a particular vendor and product.
