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It was the moment my passion for financial independence education really exploded. While reading an interview of someone who had achieved millionaire status on a modest income I saw mention of something called a 457b. It seemed like I should have access to that!
I checked, amazed that I hadn’t heard of it before. Sure enough, it’s a benefit available to most public educators. And, it’s potentially game-changing for those looking to secure financial independence and/or retire early.
In this post, I’ll explain:
- What a 457b is
- Why It’s an Amazing Benefit
- How You Access It
- How Much You Can Contribute
- Potential downsides
Oh, and before I dive in let me acknowledge my embarrassment that as a generally
not-totally-financially-ignorant person working in schools for over 15 years I didn’t know about this benefit.
This why I’m so passionate about sharing information with other educators. I missed a lot of opportunities due to lack of knowledge. I want better for you.
This one piece of knowledge significantly accelerated our path to financial independence. I hope it helps you.
What is a 457b?
Simply put, a 457(b) (named for the relevant tax code) is a deferred compensation plan available to some employees of state and local government or tax-exempt organizations. It’s not as well known as 401k and 403b options – and has important differences I will cover below.
You contribute pre-tax and your investment grows tax-deferred, just like a 401k or 403b plan. With one critical difference.
But first, an important clarification: People often offer advice and opinions about 457b without making clear an important distinction:
Governmental Vs. Non-Governmental
Governmental 457b are available to employees of state and local governments that have established a plan. Funds in governmental 457b are held for the exclusive benefit of the participant. Generally, rollovers are allowed between other 457b, 403b, 401k, and traditional IRA.
Non-governmental plans are offered by non-governmental (obviously!) tax-exempt organizations and are limited to a group of “highly compensated employees” as defined by the employer. Assets in these plans are the property of the employer until paid out and are therefore subject to the employer’s creditors. Non-governmental plans may only be rolled into other non-governmental plans, not into other types of retirement plans. Non-governmental plans are available to fewer people, not as flexible, and exposed to creditors.
The remainder of this article focuses on governmental 457b plans. This is almost always the option available to educators.
Why Is the 457 an Amazing Benefit?
My wife still makes fun of my excitement the day I discovered the 457 option. Rightly so (I was a little fired up) – but my reaction was warranted! We are still working for financial independence and undecided about early retirement. Yet, we also want to retain flexibility. That meant we needed to start increasing our brokerage investments. We were just ramping up, and then I discovered the 457!
Two reasons I consider the 457b FIRE magic:
- It’s an additional pre-tax contribution option. It effectively doubles your ability to contribute to your retirement pre-tax!
- You can access the funds upon separation from your employer with no 10% early withdrawal penalty. (You do pay tax – just not the additional penalty.)
So, for FIRE purposes, you are able to contribute more on the front end AND you don’t have to pay an additional penalty if you retire early as you do with the 401k/403b. Many also offer Roth options if that works better for your financial plan.
For the two-phase system, where you plan to leave early and need to bridge the gap until 59.5, you can spend your 457b while letting your other tax-advantaged retirement accounts grow! For this purpose, it’s the equivalent of a brokerage account that you contribute to, and grows, with pre-tax dollars!
They’re Not Actual Magic Though
Check your plan documents carefully, but you can generally rollover governmental 457b accounts into other retirement accounts (not Roth) and vice-versa. There are times where this may be advantageous. Check out this helpful rollover chart to see rollover options.
An important note: Rolling funds from previous 401k/403b accounts into a 457b is allowed in many cases. This may make sense if you are consolidating funds or your 457b offers better investment options. These funds are required to be separately tracked and accounted so the early withdrawal penalties are applied.
Rolling other retirement accounts into a 457b does not remove the early withdrawal penalty.
The Most Important Note: Rolling your 457b into an IRA removes the ability to withdraw early without a penalty! Do your research and consider your options and long-term financial plan before even considering this.
How Do You Start a 457b?
The 457b has to be offered by an employer. There is no ability to set-up a 457b through an independent brokerage. This limits the options you have available. (We’ll get to that in a bit…)
If a 457b is available, follow your employer’s procedures for opening an account. This will often begin with enrolling with the plan provider. For educators, you can generally find plan documents and enrollment forms on your district website or through your HR office.
Set-Up Payroll Withdrawals
You will contribute with payroll withdrawals and will need to follow your district’s procedures to set those up. In most plans, once you have the process started you can change your contribution amounts and investments online. Most plans allow monthly adjustments.
Of course, you need to know your contribution limits to help you decide how to approach contributions..
How Much Can I Contribute?
You’ll sometimes read that 457b contribution limits are the same as 403b. This isn’t quite accurate.
Your base annual contribution limit to a 457b account for 2019 is $19,000. This is the same limit as for 403b and both can be adjusted annually by the IRS based on cost-of-living increases.
There are two catch-up provisions that apply to a 457.
Catch-up Provision 1
Also similar to 403b, there is an over-50 catch-up allowance of $6000. So, for an educator over the age of 50, it is possible to contribute up to $25,000 in 2019. Impressive!
This is identical to 403b. Now, let’s talk about differences:
Catch-up Provision 2
If you are within 3 years of your plan’s Normal Retirement Age (varies by plan), you may be eligible for a catch-up provision that allows you to contribute double the allowed amount. If you are eligible for this provision in 2019 you can contribute up to $38,000!
Important caveats to catch-up contributions:
- You can only use one of the catch-up provisions, not both.
- You can only contribute up to 100% of your salary.
- Be sure to check your plan for normal retirement age – it isn’t standard.
One final difference. Employers can contribute to an employee’s 457. However, employer contributions are still subject to FICA taxation. Most importantly, the aggregate amount (employee + employer contributions) is the same as what the individual employee could contribute. (403b plans have a higher aggregate amount.)
That’s a lot of words – let’s look at some examples:
And remember, you are still able to contribute the full amount of 403b eligibility!
Related Post: Investing: Make Your Money Work For You (FI Basics)
Why was I so excited when I found the 457b? Both TFI and I are eligible, though not for the catch-up provisions. For 2019 – together we can contribute $38,000 to our 403b and an additional $38,000 to our 457b.
That’s $76,000 pre-tax! And again – we can access the 457s should we choose to retire early.
Why Wouldn’t I Use a 457b?
Yes, it’s a pretty great option. You may not be able to contribute the full amount, but you can start to include it as part of your financial plan. As always – I encourage you to start with whatever you can, no matter how small.
Other than your own personal financial situation, there are a few other things to be aware of. The first and most important….
Fees Can Kill 457 Magic
Fees. Fees can ruin anything.
Unfortunately, some 457b products are loaded with incredible fees. Remember, the plan has to be offered through your employer. Not all employers provide good plan options and instead partner with companies that prey on educators. Some offer only annuity products or other expensive funds.
This makes me incredibly angry for educators, and others, out there. Employers should protect staff by ensuring low fee options are available.
Instead, some educators only have horrible options that are loaded with fees. Fees erode your earning over time.
As always, check your fees. Read your plan documents carefully to determine the fees you’ll be paying and decide if they kill the magic for you.
There are Often Multiple Fees
It’s not just the investment options that are available – most 457b also have other fees.
As an example, I’m very fortunate to have access to an index option. The fee is only .05%
My options also include target date funds with fees of .12% and the highest-fee product is “only” .4%.
However, on top of the fund fee, there is also an Administrative Fee and a Recordkeeping/Custodian Fee. These two total an additional .17%. They are charged by the plan administrator.
This results in a fee range of .22% to .57%. While higher than a base index fund, .22% is excellent compared to options offered by many other employers. I’ve seen total fee loads exceeding 4%. Which is ridiculous and should be illegal. Unfortunately, it isn’t – so make sure you check for yourself.
The benefits of the 457b significantly outweigh the fees in options available to me. For some, that will not be the case.
Total all of the fees to find your total load. Decide if it is worth it for you.
Accessing funds in a 457b for emergency purposes is more restrictive than with your 403b/401k accounts. The withdrawal must be on “account of an unforeseeable emergency.” (More information on hardship distributions)
Hopefully, you have a solid financial plan that does not require such withdrawals, but I wanted to name all potential downsides.
What Does This All Mean?
If you have a government 457b available, it can be a powerful component of your financial independence plan. The only exception would be for those that are loaded with truly egregious fees that cancel out any advantage to a pre-tax investment option.
While magic may be a bit extreme, it’s safe to say that for many educators the 457b is an incredible option.
Suggestions For Action
- Check for 457b plan availability
- Learn the fees
- Prioritize your 457b or 403b based on fee structure and the possibility of early retirement
- If you are not planning an early retirement – choose the option with the lowest fees
- If you are, prioritize the 457b *if* the fees are not significantly higher
- Start a contribution today – no matter how small
How does this look for us? We are fortunate enough to be able to max out both this year. However, if that isn’t true going forward, we will prioritize the 457b due to the ability to access it early without the 10% penalty. Our 403b has slightly lower fees (.04% vs .22%) but we have significantly more invested there and want to retain the flexibility for early retirement.
A governmental 457b is a powerful option available to educators (and others working for eligible employers.)
- Contributions are pre-tax
- Contribution limits are in addition to 403b
- Accessible upon separation from your employer
- No 10% early withdrawal penalty
I hope you see why I was so excited to discover this option, and why I’m glad to share it with you.
Were you aware of 457b plans? What do your fees look like? How much are you contributing?