What Is a 457 Plan and How Does It Work?

Retirement savings plans help individuals build financial security for their later years. These arrangements often involve deferring income, allowing it to grow with tax advantages. Among the diverse landscape of retirement and deferred compensation options, the 457 plan stands as a specific type designed for a particular segment of the workforce. It allows eligible employees to set aside pre-tax earnings for long-term financial well-being.

Core Concepts of a 457 Plan

A 457 plan is a non-qualified deferred compensation plan established under Internal Revenue Code Section 457. It allows employees to defer a portion of their income, often on a pre-tax basis, for retirement savings. There are two primary types: governmental 457(b) plans and non-governmental 457(b) plans.

Governmental 457(b) plans are for employees of state and local governments, including agencies and political subdivisions. Assets in these plans are held in trust or custodial accounts for the exclusive benefit of participants and their beneficiaries. Non-governmental 457(b) plans are offered by certain tax-exempt organizations, such as hospitals and charities. For these plans, assets remain subject to the employer’s general creditors until distributed.

Who Can Participate in a 457 Plan

Participation in a 457 plan is limited to employees of specific organizations. These plans are primarily available to individuals working for state and local government entities, such as public schools, universities, police, and fire departments.

Certain tax-exempt organizations, defined under Internal Revenue Code Section 501(c), can also offer non-governmental 457(b) plans to their employees. Eligibility requires being on the payroll of one of these qualifying employers.

How Contributions Work

Contributions to a 457 plan are primarily made by the employee through pre-tax salary deferrals. The IRS sets annual limits on deferrals; for 2024, the limit is $23,000, which is subject to annual adjustments for inflation.

A unique feature is the “special 457 catch-up” provision. This allows participants nearing retirement age to contribute more than the standard annual limit during the three years immediately preceding their normal retirement age. An eligible participant may contribute up to double the annual limit, provided they have not deferred the maximum in previous years. This differs from age 50 and over catch-up contributions in other retirement plans. Employer contributions are not a standard feature of 457(b) plans, unlike some other defined contribution plans.

Accessing Your Funds

Accessing funds from a 457 plan is generally permitted upon specific events, such as separation from service, death, or disability. Distributions can also begin when the participant reaches age 70½, even if still employed. Funds withdrawn are typically taxed as ordinary income.

Governmental 457(b) plans have a significant advantage: distributions before age 59½ are generally not subject to the additional 10% early withdrawal penalty that applies to many other retirement accounts, like 401(k)s and IRAs. Non-governmental 457(b) plans, however, are typically subject to this penalty. Hardship withdrawals may be permitted, but are usually limited and only available for governmental plans.

Loan provisions are generally available only in governmental 457(b) plans, allowing participants to borrow against their account balance. Upon separation from service, participants can roll over 457 plan assets into another eligible retirement plan, such as a 401(k), 403(b), or an Individual Retirement Account (IRA). This allows for consolidation or continued tax-deferred growth in a different retirement vehicle.

Distinguishing Features of 457 Plans

Several characteristics set 457 plans apart from other common retirement savings vehicles like 401(k)s and 403(b)s. Governmental 457(b) plans have a key distinction: the absence of the 10% early withdrawal penalty for distributions taken before age 59½, which applies to many other retirement accounts. This offers public sector employees flexibility.

Another differentiating feature is the “special 457 catch-up” provision, allowing participants nearing retirement age to contribute more than the standard annual limit in the three years leading up to their normal retirement age. This differs from the age 50 and over catch-up contribution common in 401(k) and 403(b) plans.

The classification of a 457 plan as an “eligible deferred compensation plan” impacts how assets are held. For non-governmental 457(b) plans, deferred compensation remains a general asset of the employer, subject to creditor claims. In contrast, governmental 457(b) plans hold assets in trust or custodial accounts for participants, providing asset protection.

Sources

“IRS provides tax inflation adjustments for 2024,” Internal Revenue Service.