In order to build a solid house, you first need to use good bricks. For most lawyers, basic finance knowledge is pretty uneven. We know certain topics but are clueless on others. One of the goals I had with the site is to create a series that address the basics. It’s a good refresher for those that are already familiar with the topic, but an even better bank of information for people to refer to later.
Today’s topic covers 457(b) plans. Many lawyers have access to 457(b) plans, but I’d be willing to bet that most lawyers are not familiar with them.
My first foray into 457(b) plans came when I realized my then-girlfriend has access to one through work. It brought up all the usual questions, like how much can you contribute, what are the investment options, etc. It turns out 457(b) plans can be a great way to save for retirement, particularly since contribution limits to 457(b) plans are separate from contribution limits to 401(k)s.
What is a 457(b) plan?
Named after the Internal Revenue Code section 457 (of course!), 457(b) deferred compensation plans allow employees to defer compensation on a pre-tax basis. In that sense, they are quite similar to a typical 401(k) plan. The plans are available for certain state and local government and non-governmental entities that are tax exempt under IRC section 501 (like 501(c)(iii) organizations).
Employees can contribute up to $18,000 to 457(b) plans in 2016. The contributions are tax-deferred, meaning you save on your tax bill today. The earnings grow tax-free too, so you won’t need to pay taxes on your 457(b) money until you withdraw it. Some plans will allow you to make after-tax (Roth) contributions to a 457(b) plan, but most lawyers are going to see a better bang for their buck by contributing pre-tax money and taking the tax savings up front.
457(b) plans require withdrawals to start at age 70 ½ with required minimal distributions, just like 401(k) and traditional IRAs.
But in one important way, a 457(b) is better than a 401(k). 457(b) plans have no penalty for withdrawing money prior to age 59 ½. Although the 10% penalty is generally an overblown fear, this has two important advantages:
(1) Early Retirement. A lawyer interested in early retirement can plan to use 457(b) contributions to fund their early retirement. With minimal planning on your part, once you’ve early retired, you can simply siphon off the 4% from your portfolio from the 457(b) without needing to worry about anything but ordinary income taxes. For this reason alone,t he 457(b) has a prominent place in my retirement planning.
(2) No Reason to Skip Contributions. Often during the early years of a lawyer’s career, there will be many competing demands on your money. It’s easy to skip retirement contributions, particularly when building an emergency fund to gain financial security. This is one of the reasons why I advocate contributing to the Roth IRA since contributions can always be withdrawn without penalty. If you have access to a 457(b) plan, the same fear should be removed. You can make contributions today, knowing that in a worst case (and unlikely) scenario you can always take the money out later without shooting yourself in the foot.
Two types of 457(b) plans
There are two types of 457(b) plans: either governmental or non-governmental. The distinction is important and should be the first piece of information to figure out before deciding to contribute.
Governmental plans are required to be held in trust. This means that the money you contribute to a governmental plan is not exposed to potential creditors of your employer in the event of your employer’s bankruptcy. The money belongs to you and can’t be touched by anyone else.
Non-governmental plans, the kind offered by tax-exempt organizations like hospitals, charitable organizations, etc., are not held in trust. By law, the funds in these plans are technically at risk and available to creditors in a bankruptcy proceeding. While the risk is probably low that you’ll lose money to your employer’s creditors in a non-governmental 457(b) plan, it’s understandably disturbing to know that such a possibility exists. Even worse, your 457 money can only be withdrawn or transferred to another non-governmental 457 plan. It can’t be rolled over into a 401(k) or IRA.
This means that contributing to governmental plans is an easy decision. Contributing to a non-governmental plan is a little less clear. I’ve never heard of a creditor of an employer seizing the 457(b) assets, but I’m sure it happens. In the end, the benefit of saving the tax break in the current year seems to outweigh the bankruptcy risk from my perspective. If I had the option, I would choose to contribute to a non-governmental plan but I’d be sure to max out my 401(k) and backdoor Roth IRA ahead of any 457(b) contributions. In retirement, I would also make sure to withdraw the 457(b) money first.
A way to beat the $18,000 limit
Perhaps the best part of 457 plans is that if your employer also offers a 401(k), you can contribute the maximum $18,000 to both plans, for a total contribution of $36,000 in tax-deferred space. The irony isn’t lost on me that many lawyers who will have access to both 401(k) and 457 plans are lawyers working in the public sector and thus the lawyers least likely to be in a position to save $36,000 each year in retirement accounts. But if you can afford to do so, it’s a great opportunity. If you are married, there’s also an opportunity for a high earner to effectively shift their salary to the 457(b) plan. I think this is the more likely scenario for many lawyers, which would result in two maxed out 401(k)s and one maxed out 457(b). That’s a total of $54,000 in tax-deferred space each year. Not a bad deal if you can get it.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Empower keeping track of his money. He’s also maxing out tax-advantaged accounts like 529 Plans to minimize his taxable income.
I agree! 457(b)s are BOMB especially for people with dual incomes (and especially, if that second person is actually earning a decent income aka not a government employee. I just finished up a judicial clerkship and loved being able to contribute to both 457(b) and a 401(k).
That’s great that you were able to take advantage of both. I see government employee couple lawyers all the time that have a total of $72,000 in tax-deferred account space between the two of them. Unfortunately, their combined salaries often aren’t enough to fully take advantage of the space so it goes unused!
I just learned recently that there were no penalties for withdrawals from 457 plans prior to 59 1/2. That’s definitely a big plus for those who are interested in early retirement. I do not have a 401k on top of the 457 plan though I’m not sure I’d be able to max them both out either.
Argh! Another opportunity to double up on retirement savings missed, but of course I totally get it. I guess the interesting thing for you is that you have almost no use for having a taxable investment account. Given that you can withdraw the 457 money without penalty, I guess it does make it easier for you to push yourself on possibly over-contributing to retirement accounts since you can use the 457 as an effective emergency fund should you need it.
Yea, I maxed out but my wife has a 457 plan also which we could max out too. You can withdraw it without penalty but that is only if you leave your employer so I don’t feel as comfortable using it as an emergency fund.
Good point. In my example above, the emergency would have to be the loss of your job. Although, I think there are a few hardship exemptions available for 457 plans. But you’re right that it’s definitely not as flexible as say a Roth IRA.
My employer went bankrupt and my NP 457(b) funds were seized by the hospital’s creditors. Can I deduct this loss on my taxes, or do I have any recourse to recover the state and FICA taxes I paid on my contributions?
Yikes. That doesn’t sound fun. Thanks for sharing and reminding everyone that 457(b) plans can go poorly. I would bring in a CPA to help on something like this. Really sorry to hear about your outcome.