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Common Questions about 457b Plans
What is a 457b?
A 457b is a type of retirement plan available to employees of state and local governments and some tax-exempt organizations. It is a way for employees to save for their retirement by having part of their paycheck deposited into the plan. Employers can choose to match the employee's contributions and also deposit money into the employee's account. This is a way for employers to help their employees save for retirement without operating extensive pension plans.
To better understand how a 457b operates, consider the following example. Mayberry County allows employees to contribute to the county's 457b plan. Mayberry County will match incrementally up to 3% of the employees' contribution. If Alison, a county clerk, contributes 3%, Mayberry County will contribute 2% to her account. If Alison contributes 4%, Mayberry County will contribute 2.5%, and if she contributes 5% or more, the Mayberry County will contribute 3%.
As you can see, if Mayberry County provides matching contributions, Alison can increase the amount of money she receives above and beyond her salary. If Alison makes $30,000 in 2007 and contributes 5%, Mayberry County will contribute an additional 3%. As a result, she will receive $30,000 plus $900 additional money from Mayberry County's matching contributions. Alison's total compensation will be $30,900 instead of $30,000 simply because she participates in Mayberry County's plan.
However, be cautious. The rules sometimes differ depending on whether the plan is set up by a governmental entity or other type of tax-exempt entity. Make sure to verify with your plan administrator or financial advisor what the differences in the rules are.
Who is eligible to participate in a 457b plan?
Only certain types of workers can participate. They are:
- Employees or independent contractors of state and local governments, and
- Highly compensated employees and independent contractors of tax-exempt organizations.1
Unlike 403b's, the 457b specifically excludes churches from participation.2
How does a 457b work?
Your employer withholds a certain amount of your paycheck and deposits that money, along with any matching contributions, into your account. The money in the 457b plan is invested in various financial instruments, such as mutual funds. The money stays in the account until you reach a certain age when it is legal to withdraw the money, or under any of the several exceptions to the age rule. This causes the plan to earn money through compounding, so your account grows not only through regular contributions made from your paycheck but also by earning interest or dividends.3
What is a company match?
A company match is when employers agree to contribute certain amounts to your 457b in addition to your own contributions. Employers may decide to make a contribution above and beyond what you decide to contribute. This is a way to reward employees for their service and is often seen as a positive benefit which can attract good employees to the organization and keep them there.
How do I make contributions to a 457b?
You make a contribution through your employer. If you decide to participate in the plan, you will determine what amount of your paycheck that you want to be deposited in your plan, and your employer will withhold that amount from each paycheck you receive. The employer deposits the withheld money into your account, along with any matching contributions.4
Are there any limitations to making a contribution to a 457b?
The limit for total contributions, both employee and employer-matching, in 2007 and 2008 is $15,500 per person. So, for example, if Alison contributes $10,000 to her account, her employer can only contribute an additional $5,500.5
If my employer becomes bankrupt before I retire and receive my money from my 457b, what happens?
If your employer is a tax-exempt organization, both your contributions and any matching employer contributions are subject to the organizations creditors. Therefore, your money can be taken to pay debts of your employer.
If your employer is a governmental entity, your share of the contributions is 100% vested the moment you start participating in the plan. Generally, this means that you always keep full rights to your contributions. Your employer's matching contributions may vest over time according to the rules of the plan. Until they do, those matching contributions can be subject to the claims of the employer's creditors.6
When can I withdraw my money from a 457b? Do I have to be a certain age?
You must begin taking distributions after reaching age 70 ½. However, unlike other deferred compensation plans, this plan does not make you wait until age 59 ½ to receive other penalty-free distributions. There are two circumstances when you can receive distributions prior to reaching age 70 1/2:
1. When the employee severs employment with the employer, or
2. When the employee is faced with an unforeseeable emergency.7
You will still owe federal income tax on the distributions no matter what the circumstance of the distribution.
How do you maintain a 457b?
You maintain your account by making contributions to it through your employer. The contributions are withheld from your paycheck, and any matching contributions your employer will add to yours are deposited into the plan by your employer.8
If I quit my job where I was participating in a 457b plan, what happens?
These plans allow you to begin receiving distributions of money penalty-free when you quit your job with the state or local government or tax-exempt organization. However, you will still owe normal federal income taxes on the money since contributions were not taxed when you made them.9
Can I rollover or transfer the money in my 457b if I quit my job?
It depends on which type of entity you work for. If you work for a state or local government, rollovers are generally permitted. If you begin working for another state or local government, you may also transfer the money into your new employer's plan.
If you work for a tax-exempt organization, you are typically NOT allowed to rollover your money in your account. However, you are permitted to transfer it to another tax-exempt 457b if you begin a new job.10
Can I start a 457b if I already have an IRA?
Yes, you absolutely can participate if you also have IRA's, Traditional or Roth.
How does a 457b affect my federal income tax?
Contributions are considered elective deferrals of income, so you do not pay any federal income tax on them in the year you make the contribution. For example, John contributes $1,000 to his 457b in 2007, and his employer contributes $200. John's salary for the year is $30,000. He will pay federal income taxes on $29,000, which is his salary minus his $1,000 contribution.
However, you do not get away completely tax-free. When you take distributions from your 457b plan, you will owe federal income taxes on that money then. For example, if Susan is age 75 and receives a $10,000 distribution in 2007, she will owe taxes. However, when she contributed to the plan years ago, she did not have to pay any taxes on the money then.11
What happens to my 457b plan after I die?
You may designate beneficiaries who will inherit your plan after your death.12
Why participate in a 457b? Why not just invest that money in mutual funds?
By participating, you receive tax benefits that you would not receive by investing your money in mutual funds on your own. The money you contribute is not subject to income tax. Therefore, you end up paying fewer taxes by participating than if you bought mutual funds on your own. For example, Alison works for Mayberry County Board of Education. She makes $30,000 and contributed $1,500 to her 457b. She will owe federal income taxes on $28,500, not on her full salary of $30,000. She gets to deduct the 457b contributions from her income before calculating taxes owed. If Alison had used the $1,500 to buy mutual funds through her stockbroker, she would have owed taxes on any earnings from the funds that year.
Another reason to participate is that in most plans, employers match a portion of your contributions, so it is as if your employer is giving you free money simply by participating in the plan! To continue the above example, Alison makes $30,000 in 2007 and contributes $1,500 to her 457b plan in 2007. Mayberry County provides matching contributions of $1,000, so she really makes $31,000 in 2007, not just her $30,000 base salary. However, the big benefit is that she owes taxes on $28,500 instead of $31,000.
This article has covered common questions investors typically have when learning about 457b plans. This article does not cover all aspects of the plan, but it is designed to give you an overview of what the plan is and how it works. For additional information or specific questions, contact your plan administrator or financial advisor.
References
United States Internal Revenue Service, Publication 560, Retirement Plans for Small Businesses, "Qualified Plans", http://www.irs.gov/publications/p560/ch04.html
United States Internal Revenue Service, Publication 571, Tax Sheltered Annuity Plans (457b Plans), http://www.irs.gov/publications/p571/
United States Internal Revenue Service, Publication 4484, Choose a Retirement Plan for Employees of Tax Exempt and Government Entities, http://www.irs.gov/pub/irs-pdf/p4484.pdf
United States Code, Title 26, Subtitle A, Chapter 1, Subchapter E, Part II, Subpart B, § 457.
http://www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00000457----000-.html
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