457b vs 401k: Key Differences You Need to Know

Retirement planning is a key aspect of financial security, and understanding the differences between various retirement plans can significantly impact your future. Two common options are 457(b) and 401(k) plans, each with features tailored to different employment sectors and individual needs.

Eligibility Requirements

Eligibility for 457(b) and 401(k) plans depends on your employment sector. The 457(b) plan is generally available to employees of state and local governments and certain non-profit organizations, such as teachers, police officers, and municipal workers. In contrast, 401(k) plans are primarily offered to private-sector employees across various industries. This distinction stems from their regulatory frameworks: 457(b) plans are governed by the Internal Revenue Code Section 457, while 401(k) plans fall under Section 401(k).

Employer eligibility also varies. A 457(b) plan can be established by governmental entities or tax-exempt organizations. Meanwhile, 401(k) plans are offered by private companies, including corporations, partnerships, and sole proprietorships. These differences reflect the plans’ design to meet the needs of their respective sectors.

Contribution Limits

Understanding contribution limits is essential for maximizing retirement savings. For 2024, both 457(b) and 401(k) plans have a contribution limit of $23,000, with adjustments for inflation. Those aged 50 and above can make an additional $7,500 in catch-up contributions, increasing the total to $30,500. These provisions help individuals enhance their savings as they approach retirement or compensate for starting later in life.

Contribution limits are subject to annual IRS adjustments based on cost-of-living changes. Staying informed about these updates is crucial for fully utilizing tax-advantaged savings opportunities.

Tax Treatment

Both 457(b) and 401(k) plans offer tax advantages that reduce current tax liabilities. Contributions to these plans are pre-tax, lowering taxable income in the year of contribution. For instance, an individual in the 24% tax bracket contributing $23,000 in 2024 could save $5,520 in taxes that year. This tax deferral supports greater accumulation of retirement savings.

Withdrawals from both plans are taxed as ordinary income. However, 457(b) plans offer greater flexibility by not imposing an early withdrawal penalty for distributions before age 59½, making them attractive for early retirees. In contrast, 401(k) plans typically impose a 10% penalty for early withdrawals unless specific exceptions apply.

Roth options are available in both plans, allowing after-tax contributions with the potential for tax-free withdrawals in retirement, provided certain conditions are met. This can benefit those anticipating a higher tax bracket in retirement or seeking tax diversification.

Distribution and Withdrawal

The distribution and withdrawal rules differ significantly between the two plans. 457(b) plans allow penalty-free distributions upon separation from service, regardless of age, making them appealing for those planning early retirement or needing access to funds sooner.

401(k) plans generally require participants to wait until age 59½ to withdraw funds without penalties. However, hardship withdrawals are available for immediate financial needs, subject to IRS guidelines and taxes.

Rollover Options

Both 457(b) and 401(k) plans allow rollovers, but the rules differ. Governmental 457(b) plans permit rollovers into a broader range of accounts, including other 457(b) plans, 401(k) plans, 403(b) plans, or IRAs, while non-governmental 457(b) plans have more restrictions.

401(k) plans allow rollovers into another 401(k), a 403(b), a governmental 457(b), or an IRA. Rollovers must be completed within 60 days to avoid penalties, with direct rollovers preferred to prevent tax withholding. Additionally, 401(k) plans may permit reverse rollovers, enabling participants to transfer IRA funds into a 401(k), which can help delay required minimum distributions.

Employer Involvement

Employer contributions and involvement vary between the two plans. In 457(b) plans, employer contributions are less common, particularly in non-governmental plans. Governmental 457(b) plans may offer employer contributions, but these are subject to the same annual contribution limits as employee contributions. Employers primarily focus on providing access to the plan and ensuring regulatory compliance.

401(k) plans often include employer matching contributions, which significantly enhance retirement savings. A common formula might be 50% of employee contributions up to 6% of salary. Employers also play a role in selecting investment options and features like automatic enrollment, simplifying participation and improving outcomes.

Vesting Terms

Vesting terms determine when participants gain full ownership of employer contributions. Employee contributions to 457(b) plans are always 100% vested. Governmental 457(b) plans typically offer immediate vesting for employer contributions, while non-governmental plans may impose vesting schedules.

401(k) plans frequently include vesting schedules for employer contributions, such as cliff vesting, which grants full ownership after a set period, or graded vesting, which gradually increases ownership over time. Participants should review their plan’s vesting schedule to ensure they maximize employer contributions before leaving a job.