457(b) Disadvantages: What You Need to Know

Understanding the potential drawbacks of a 457(b) plan is crucial for anyone considering this retirement savings option. While these plans can be beneficial in certain scenarios, they also come with limitations that may impact long-term financial planning.

Limited Contribution Limits

The 457(b) plan provides tax advantages for retirement savings but has contribution caps that may be restrictive for high-income earners or those aiming to accelerate their savings. As of 2024, the annual contribution limit is $22,500, comparable to 401(k) and 403(b) plans. Individuals over 50 can increase this limit with a catch-up contribution of $7,500, reaching $30,000. Additionally, the “special catch-up” provision allows contributions up to $45,000 annually in the three years before retirement age, but eligibility criteria and careful planning are required.

Early Withdrawal Penalties

One notable feature of the 457(b) plan is the ability to withdraw funds without penalties after leaving a job, regardless of age. While this flexibility is appealing, distributions are subject to ordinary income tax, reducing the net amount received. Early withdrawals can also diminish the account’s growth potential, impacting long-term savings.

Lack of Employer Match

A disadvantage of the 457(b) plan is the absence of employer matching contributions, a key benefit of many 401(k) plans. Employer matches can significantly boost retirement savings, effectively amplifying employee contributions. Without this feature, employees may find other plans with matching benefits more attractive, affecting overall retirement preparedness.

Investment Options Limitations

457(b) plans often restrict participants to a limited selection of investment options, such as mutual funds and fixed-income choices. This lack of variety can hinder portfolio diversification, making it harder to align investments with personal risk tolerance or strategy. It also limits the ability to capitalize on specific market opportunities, potentially affecting long-term growth.

Tax Implications at Withdrawal

Withdrawals from a 457(b) plan are taxed as ordinary income, which can reduce the net value of retirement savings. Contributions are pre-tax, meaning both withdrawals and earnings are taxable. This could lead to a significant tax burden, especially if other income sources push retirees into a higher tax bracket. Strategic timing of withdrawals can help mitigate tax consequences, but Required Minimum Distributions (RMDs) starting at age 73 must also be considered. State income taxes may further affect the after-tax value of withdrawals.

Impact on Social Security Benefits

Withdrawals from a 457(b) plan, while not subject to Social Security taxes, are included in “provisional income,” which determines the taxability of Social Security benefits. If provisional income exceeds specific thresholds, up to 85% of benefits may become taxable. This can create a “tax torpedo,” increasing the marginal tax rate. Retirees should consider strategies like spreading withdrawals over multiple years or coordinating with other income sources to minimize tax impacts.

Administrative Fees and Costs

Administrative fees associated with 457(b) plans can erode investment returns over time. These fees, which include recordkeeping and investment management expenses, are often charged as a flat amount or a percentage of assets. Over the long term, such costs can significantly reduce retirement savings growth. Participants should carefully review fee disclosures and compare them to other retirement savings options to ensure cost-effectiveness.