State and local government jobs have some big advantages. Benefits such as pensions and access to tax-advantaged government retirement plans called 457(b) plans make working for government pretty rewarding.
Employees of the federal government have a thrift savings plan rather than a 457(b) plan.
How the 457(b) plan works
A 457(b) is a lot like a 401(k). “It’s very similar in that you can only defer a certain dollar amount each year, and the amount you can defer is linked to the cost-of-living (indexes), as the 401(k) is,” says Dominick Pizzano, a New Jersey-based compliance consultant at Milliman, an actuarial and consulting firm.
The contribution limit is $18,000 for 2017. The limit rises to $18,500 in 2018. If the plan allows it, a participant can make Roth contributions to his retirement account, paying taxes on the contribution before it goes into the account. Interest and earnings would be tax-free in retirement.
Also similar to the 401(k) is one of the catch-up provisions that allows workers age 50 and up to contribute an additional $6,000.
Now for the curveball: 457(b) plans also may allow workers to save extra money starting three years before the “normal retirement age,” which is specified in the plan. The normal retirement age can vary, but the special contributions can begin three years before that point.
“So if someone was to retire at 50, at 48 they could begin the 457 catch-up because it’s three years prior to their retirement age. It’s called the three-year rule,” says Julia Durand, a former director at CalSTRS (California State Teachers Retirement System).
Here’s the deal: Employees can contribute the lesser of twice the normal elective deferral limit or the sum of the current year’s ceiling plus unused portions from prior years.
Essentially, for 2017, it would be $36,000, or $18,000 plus the sum of all the money you didn’t put in but could have in previous years, whichever is less.
The formula sounds a bit convoluted — and it can be that way on the administrative end as well. That’s why plan administrators sometimes choose not to offer it as a catch-up option.
“It requires information to calculate that the employers may not always have available to them. If an employee wants to participate in catch-up, they have to provide the payroll records that show they did not contribute the full amount they could have for past years,” Durand says.
Employer matches are rare
State and local government employers rarely provide matches to employees. Unlike with 401(k) and 403(b) plans in which the $18,000 limit applies only to employee deferrals, if a government employer does make a contribution to a 457(b) plan, it counts toward the total allowable limit for the year.
For instance, if a local government employer contributes $1,000 in 2017, the employee may only contribute $17,000. However, a government employer could theoretically kick in the entire yearly limit if it wants.
Fees may be higher
Since most government employees have a pension, a defined contribution plan such as a 457(b) is considered a supplemental savings plan, which is why an employer match is uncommon.
As government employers can’t lure workers into the 457(b) savings plan with free money, they may sign up for services that end up costing participants a little bit more but will encourage them to save.
“The 457 plan doesn’t have a match, and it doesn’t really sell itself,” says Andrew Ness, a consultant at Mercer Investment Consulting.
“What is seen more commonly in the 457 market that isn’t as prevalent in the 401(k) market is an on-site education representative model — so, having people physically visit to educate employees and enroll them in the plans,” Ness says.
Bringing in representatives can drive up plan participants’ fees. But there are other factors that influence the cost of 457 plans to workers, such as the size of the plan.
Similar to the corporate world, larger plans have more leverage than smaller ones to negotiate fees.
“Smaller plans usually have kind of a product in the box, and providers need to have a little bit more profit margin to service the small plan, so the fees are probably a little bit higher in those plans,” Ness says.
The plan administrator also can make a difference. “Some 457s offer more competitive fee structures than 401(k) plans and vice versa. It depends who’s at the helm and if their fiduciary responsibilities are taken seriously,” Durand says.
Withdrawals and early distributions
When it comes to breaking into the account early, 457(b) plans make it a little harder to withdraw money in an emergency.
“A 457 plan can only make hardship distributions if the participant has no other resources available. They would have to exhaust any monies they had in other places. Then, if they took a distribution from the 457, they would have to stop making deferrals for a certain period of time,” says Jimmy Williamson, a partner and CPA at Alabama-based MDA Professional Group, P.C.
Also, to qualify for a hardship withdrawal, the funds must be not only for an emergency but an unforeseeable one.
“In the 401(k) plan, if you needed money to buy a house or to pay tuition for a dependent, you could do that. But in the 457 plan, those types of foreseeable withdrawals are not allowed. It has to be something catastrophic, like a fire without adequate insurance to replace your house,” Pizzano says.
The good news is, distributions to workers who retire early are less taxing. Early distributions, before age 59 1/2, from 457(b) plans are not subject to the 10 percent penalty.
There’s a good reason for that, Durand says.
“Typically, police and fire departments were the participants in 457 plans for counties or municipalities. And typically, they would retire early on a disability,” she says. If the 457 plan didn’t have the exemption for early distribution, those workers would have been penalized.
That particular provision often comes under scrutiny by those who want to make all defined contribution plans the same, Durand says. There has been legislation proposed to combine these types of plans, but it is complicated.
Penalty-free withdrawals before age 59 1/2 could be a double-edged sword. Unless the money is needed, keeping it invested in a tax-sheltered account as long as possible is nearly always the best option for building wealth.
Government employees do get a few bonuses that private-sector workers might envy — namely the pension. But when it comes to defined contribution plans, the 457(b) has more in common with its corporate counterpart, the 401(k), than it has differences.