By Rebecca Lake
Original post by SoFi and republished with permission.
Depending on where you work, you may be able to save for retirement in a 457 plan or a 401(k). While any employer can offer a 401(k), a 457 plan is commonly associated with state and local governments and certain eligible nonprofits.
Both offer tax advantages, though they aren’t exactly the same when it comes to retirement saving. Understanding the differences between a 457 retirement plan vs. 401(k) plans can help you decide which one is best for you.
And you may not have to choose: Your employer could offer a 401(k) plan and a 457 plan as retirement savings options. If you’re able to make contributions to both plans simultaneously, you could do so up to the maximum annual contribution limits — a terrific savings advantage for individuals in organizations that offer both plans.
A 401(k) is a tax-advantaged, defined contribution plan. Specifically, it’s a type of retirement plan that’s recognized or qualified under the Employee Retirement Income Security Act (ERISA).
With a 401(k) plan, the amount of benefits you can withdraw in retirement depends on how much you contribute during your working years and how much those contributions grow over time.
Understanding 401(k) Contributions
A 401(k) is funded with pre-tax dollars, meaning that contributions reduce your taxable income in the year you make them. And withdrawals are taxed at your ordinary income tax rate in retirement.
Some employers may offer a Roth 401(k) option, which would enable you to deposit after-tax funds, and withdraw money tax-free in retirement.
401(k) Contribution Limits
The IRS determines how much you can contribute to a 401(k) each year. For 2022, the annual contribution limit is $20,500; $22,500 in 2023. Workers age 50 or older can contribute an additional $6,500 in catch-up contributions. Generally, you can’t make withdrawals from a 401(k) before age 59 ½ without incurring a tax penalty. So, if you retire at 62, you can avoid the penalty but if you retire at 52, you wouldn’t.
Employers can elect to make matching contributions to a 401(k) plan, though they’re not required to. If an employer does offer a match, it may be limited to a certain amount. For example, your employer might match 50% of contributions up to the first 6% of your income.
401(k) Investment Options
Money you contribute to a 401(k) can be invested in mutual funds, index funds, target-date funds, and exchange-traded funds (ETFs). Your investment options are determined by the plan administrator. Each investment can carry different fees, and there may be additional fees charged by the plan itself.
The definition of retirement is generally when you leave full-time employment and live on your savings, investments, and other types of income. So remember that both traditional and Roth 401(k) accounts are subject to required minimum distribution (RMD) rules beginning at age 72. That’s something to consider when you’re thinking about your income strategy in retirement.
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Vesting in a 401(k) Retirement Plan
A 401(k) plan is subject to IRS vesting rules. Vesting determines when the funds in the account belong to you. If you’re 100% vested in your account, then all of the money in it is yours.
Employee contributions to a 401(k) are always 100% vested. The amount of employer-matching contributions you get to keep can depend on where you are on the company’s vesting schedule. Amounts that aren’t vested can be forfeited if you decide to leave your job or you retire.
Employer’s may use a cliff vesting approach in which your percentage of ownership is determined by year. In year one and two, your ownership claim is 0%. Once you reach year three and beyond, you’re 100% vested.
With graded vesting, the percentage increases gradually over time. So, you might be 20% vested after year two and 100% vested after year six.
All employees in the plan must be 100% vested by the time they reach their full retirement age, which may or may not be the same as their date of retirement. The IRS also mandates 100% vesting when a 401(k) plan is terminated.
A 457 plan is a deferred compensation plan that can be offered to state and local government employees, as well as employees of certain tax-exempt organizations. The most common version is the 457(b); the 457 (f) is a deferred compensation plan for highly paid executives. In certain ways, a 457 is very similar to a 401(k).
- Employees can defer part of their salary into a 457 plan, and those contributions are tax-deferred. Earnings on contributions are also tax-deferred.
- A 457 plan can allow for designated Roth contributions. If you take the traditional 457 route, qualified withdrawals would be taxed at your ordinary income tax rate when you retire.
- Since this is an employer-sponsored plan, both traditional and Roth-designated 457 accounts are subject to RMDs once you turn 72.
- For 2022, the 457 plan annual contribution limit is $20,500. Catch-up contributions of $6,500 are allowed for workers who are 50 or older. For 2023, the annual contribution limit is $22,500, and $7,500 for the catch-up amount.
One big difference with 457 plans is that these limits are cumulative, meaning they include both employee and employer contributions rather than allowing for separate matching contributions the way a 401(k) does.
Another interesting point of distinction for older savers: If permitted, workers can also make special catch-up contributions for employees who are in the three-year window leading up to retirement.
They can contribute the lesser of the annual contribution limit or the basic annual limit, plus the amount of the limit not used in any prior years. The second calculation is only allowed if the employee is not making regular catch-up contributions.
Vesting in a 457 Retirement Plan
Vesting for a 457 plan is similar to vesting for a 401(k), but you generally can’t be vested for two full years. You’re always 100% vested in any contributions you make to the plan. The plan can define the vesting schedule for employer contributions. For example, your job may base vesting on your years of service or your age.
As with a 401(k), any unvested amounts in a 457 retirement plan are forfeited if you separate from your employer for any reason. So if you’re planning to change jobs or retire early, you’d need to calculate how much of your retirement savings you’d be entitled to walk away with, based on the plan’s vesting schedule.
457 vs 401(k): Comparing the Pros
When comparing a 457 plan vs. 401(k), it’s important to look at how each one can benefit you when saving for retirement. The main advantages of using a 457 plan or a 401(k) to save include:
- Both offer tax-deferred growth
- Contributions reduce taxable income
- Employers can match contributions, giving you free money for retirement
- Both offer generous contribution limits, with room for catch-up contributions
- Both may offer loans and/or hardship withdrawals
Specific 457 Plan Advantages
A 457 plan offers a few more advantages over a 401(k).
Unlike 401(k) plans, which require employees to wait until age 59 ½ before making qualified withdrawals, 457 plans allow withdrawals at whatever age the employee retires. And the IRS doesn’t impose a 10% early withdrawal penalty on withdrawals made before age 59 ½ if you retire (or take a hardship distribution).
Also, independent contractors can participate in an organization’s 457 plan.
And, as noted above, 457 plans have that special catch-up provision option, for those within three years of retirement.
457 vs 401(k): Comparing the Cons
Any time you’re trying to select a retirement plan, you also have to factor in the potential downsides. In terms of the disadvantages associated with a 457 retirement plan vs. 401(k) plans, they aren’t that different. Here are some of the main cons of both of these retirement plans:
- Vesting of employer contributions can take several years, and plans vary
- Employer matching contributions are optional, and not every plan offers them
- Both plans are subject to RMD rules
- Loans and hardship withdrawals are optional
- Both can carry high plan fees and investment options may be limited
Perhaps the biggest con with 457 plans is that employer and employee contributions are combined when applying the annual IRS limit. A 401(k) plan doesn’t have that same requirement so you could make the full annual contribution and enjoy an employer match on top of it.
457 vs 401(k): The Differences
The most obvious difference between a 401(k) vs. 457 account is who they’re meant for. If you work for a state or local government agency or an eligible nonprofit, then your employer can offer a 457 plan for retirement savings. All other employers can offer a 401(k) instead.
Aside from that, 457 plans are not governed by ERISA since they’re not qualified plans. A 457 plan also varies from a 401(k) with regard to early withdrawal penalties and the special catch-up contributions allowed for employees who are nearing retirement. Additionally, a 457 plan may require employees to prove an unforeseeable emergency in order to take a hardship distribution.
A 457 plan and a 401(k) can offer a different range of investments as well. The investments offered are determined by the plan administrator.
457 vs 401(k): The Similarities
Both 457 and 401(k) plans are subject to the same annual contribution limits, though again, the way the limit is applied to employer and employee contributions is different. With traditional 401(k) and 457 plans, contributions reduce your taxable income and withdrawals are taxed at your ordinary income tax rate. When you reach age 72, you’ll need to take RMDs unless you’re still working.
Either plan may allow you to take a loan, which you’d repay through salary deferrals. Both have vesting schedules you’d need to follow before you could claim ownership of employer matching contributions. With either type of plan you may have access to professional financial advice, which is a plus if you need help making investment decisions.
457 vs 401(k): Which Is Better?
A 457 plan isn’t necessarily better than a 401(k) and vice versa. If you have access to either of these plans at work, both could help you to get closer to your retirement savings goals.
A 401(k) has an edge when it comes to regular contributions, since employer matches don’t count against your annual contribution limit. But if you have a 457 plan, you could benefit from the special catch-up contribution provision which you don’t get with a 401(k).
If you’re planning an early retirement, a 457 plan could be better since there’s no early withdrawal penalty if you take money out before age 59 ½. But if you want to be able to stash as much money as possible in your plan, including both your contributions and employer matching contributions, a 401(k) could be better suited to the task.
Investing in Retirement With SoFi
If you’re lucky enough to work for an organization that offers both a 457 plan and a 401(k) plan, you could double up on your savings and contribute the maximum to both plans. Or, you may want to choose between them, in which case it helps to know the main points of distinction between these two, very similar plans.
Basically, a 401(k) has more stringent withdrawal rules compared with a 457, and a 457 has more flexible catch-up provisions. But a 457 can have effectively lower contribution limits, owing to the inclusion of employer contributions in the overall plan limits.
The main benefit of both plans, of course, is the tax advantaged savings opportunity. The money you contribute reduces your taxable income, and grows tax free (you only pay taxes when you take money out). Ready to set up your retirement? With SoFi Invest, you can open a traditional or Roth IRA, or a SEP IRA if you’re self-employed. It’s easy to build a diversified portfolio and you can choose hands-on investing or an automated approach to fund your retirement goals.
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