What Is a 457(b) Plan and How Does It Work?

A 457(b) plan is a tax-advantaged retirement savings account offered by state and local governments and tax-exempt organizations. It functions as a deferred compensation plan, allowing eligible employees to set aside a portion of their salary before taxes. This pre-tax contribution reduces current taxable income, and the funds grow tax-free until withdrawn, typically during retirement.

Understanding 457(b) Plan Types

There are two main categories of 457(b) plans: governmental and non-governmental. Governmental 457(b) plans are sponsored by state and local government entities. These plans typically hold participant funds in a trust or custodial account for the exclusive benefit of employees. This arrangement provides participants with creditor protection, meaning assets are safeguarded from the employer’s creditors, similar to a 401(k) plan.

Non-governmental 457(b) plans are offered by tax-exempt organizations, such as non-profit hospitals or charities. These plans are “unfunded,” meaning assets are not held in a separate trust but remain part of the employer’s general assets. In the event of employer financial distress or bankruptcy, these funds are subject to the claims of the organization’s general creditors.

The Internal Revenue Service (IRS) highlights that while governmental 457(b) plans share characteristics with qualified plans like 401(k)s, non-governmental plans operate under different rules. For non-governmental plans, contributed money is technically still an asset of the employer until distributed. This difference in asset protection and ownership is a consideration for participants.

Contribution Rules

Contributions to a 457(b) plan are made through elective deferrals, where employees contribute a portion of their salary before taxes. The IRS sets annual limits on these contributions, which can be adjusted for cost-of-living. Both employee and employer contributions count towards this annual limit.

Participants aged 50 or older can make additional “catch-up” contributions beyond the standard annual limit. A unique feature of 457(b) plans is the special 3-year catch-up provision. This allows eligible participants, typically in the three years before their plan-defined normal retirement age, to contribute up to double the standard annual limit.

To use the special 3-year catch-up, participants must have “under-contributed” in prior eligible years, meaning they did not contribute the maximum allowed amount. A participant cannot use both the age 50+ catch-up and the special 3-year catch-up in the same calendar year. Individuals must determine which catch-up provision allows them to contribute the greater amount based on their circumstances and past contributions.

Distribution Rules

Distributions from a 457(b) plan are generally permitted upon separation from service, reaching age 70½, death, or an unforeseeable emergency. A key advantage of governmental 457(b) plans is that withdrawals are not subject to the 10% early withdrawal penalty, which applies to other retirement accounts before age 59½. This provides governmental plan participants flexibility to access funds without penalty upon separation from service, regardless of age.

This early withdrawal penalty exemption does not apply to non-governmental 457(b) plans. Withdrawals from both governmental and non-governmental plans are taxed as ordinary income when received. Required Minimum Distributions (RMDs) generally begin for 457(b) plans when participants reach a certain age, similar to other retirement accounts.

Key Characteristics

Contributions to a 457(b) plan are made on a pre-tax basis, deducted from an employee’s gross income before taxes. This reduces current taxable income, providing an immediate tax benefit. Funds and earnings grow on a tax-deferred basis, with taxes paid only upon withdrawal during retirement.

A 457(b) plan is a form of non-qualified deferred compensation. This means they are not subject to some regulations as qualified plans like 401(k)s, particularly for non-governmental plans. Individuals can contribute to both a 457(b) plan and another employer-sponsored retirement plan, such as a 401(k) or 403(b), simultaneously. This allows for higher overall tax-deferred savings, as 457(b) contribution limits are separate from 401(k)s and 403(b)s. All distributions from a traditional 457(b) plan are taxed as ordinary income upon withdrawal.