457(b) vs 401(k)
What Is a 457(b) Plan?
Congress created the 457(b) plan in 1982 to allow employees of state and local governments, as well as tax-exempt organizations, to set aside money for retirement on a pre-tax basis.
Since then, employees of for-profit companies have been able to participate if their employer allows it.
How Does It Work?
Employers can contribute to 457 plans in one of two ways: matching contributions or nonelective contributions, which is often referred to as a “top-hat” contribution.
While it is common for employers to match employee contributions dollar-for-dollar, there are no legal requirements that state they must do so.
Employer contributions are treated like your contributions for tax purposes, meaning they are not taxed unless the money is withdrawn before you reach 59½ years old.
There’s also an annual limit to how much an employer can contribute to these plans each year. For 2021, the limit is $19,500 per year.
If you are over 50 years old, there is an additional catch-up contribution available to you. This allows you to make up to an additional $6,500 in contributions each year.
This money grows tax-deferred until you make withdrawals. Meaning, you won’t have to pay any taxes on the money until you withdraw it from your account.
These contributions are also known as “top-hat” contributions because they generally come from employers that haven’t elected to contribute matching money.
Here, 457(b) plans can be funded by top-hat employer contributions, but it’s not required under the law.
If your employer decides to make this type of contribution, it’s up to their discretion how much they contribute.
Top-hat contributions are only taxed when you withdraw the money from your account, so there is no limit on how much an employer can contribute.
Benefits of 457(b) Plan
457(b) plans offer tax-deferred growth, meaning that you won’t pay taxes on your investment earnings until you withdraw the money from your account.
Many workers like this because it allows them to use their pre-tax dollars to grow their savings without paying taxes on those dollars each year.
Another benefit is that there are no required minimum distributions, or RMDs. This allows the money in your account to continue growing tax-deferred throughout your retirement years.
What Is a 401(k) Plan?
401(k) plans have been offered by employers since the mid-1980s, and have become the most commonly used retirement plan in the United States.
The plan is available to employees of any company, even if their employer doesn’t offer a pension plan or other type of retirement plan.
Employees are permitted to contribute up to $19,500 for 2021 ($26,000 if over 50 years old), which is a pre-tax deduction from their income.
The investments in these plans are typically handled by a third-party firm that establishes the plan on behalf of your employer.
Unlike 457(b) plans, 401k plans do not have annual contribution limits, provided you make less than $58,000, or $64,500 if you are older.
How Does It Work??
These plans allow employees to choose which investments they want in their account.
Typically, an employer offers a handful of investment options that are then reflected in your account. It’s up to you to decide how much money to contribute and how that money gets invested.
Money grows tax-deferred, meaning you’ll only have to pay taxes on your 401k when you make withdrawals after retirement.
Benefits of 401(k) Plan
Since the investment options are typically managed by a third-party company, they usually have lower costs than most investments you could purchase on your own.
This reduces the fees you pay each year, which can help your money grow faster.
401k plans also offer additional benefits through matching contributions. This is where an employer will match every dollar that you contribute to your account.
If an employer offers a 3% matching contribution, that means they will match up to 3% of your contributions. This is free money from the company and can really help you grow your nest egg faster over time.
Key Differences Between 457(b) and 401(k)
There are key differences between the two plans and it’s important to understand what those differences mean for your retirement results. The most significant factors include:
457(b) plans are limited to employees of state and local governments, as well as tax-exempt organizations.
401(k) plans, on the other hand, can be offered by any employer.
You can contribute to a 457(b) plan regardless of whether or not your employer does. The only stipulation is that the total contribution cannot exceed the lesser of $19,500 or 100% of taxable compensation for 2021 ($26,000 if over 50 years old).
With 401k plans, the employer must match contributions at some level. If they don’t, employees are limited to pre-tax contributions of $19,500 for 2021 ($26,000 if over 50 years old).
Catch – Up Contributions
The catch-up contribution rules allow employees over 50 to contribute an additional $6,000 a year into their 457 plans, on top of the max contributions outlined above.
401(k)s do not offer this benefit, but there are no limits as to how much you can contribute pre-tax each year.
Taxation of Contributions and Withdrawals
Both plans require you to start withdrawing money from your account once you turn 59.5 years old, but 457(b)s have slightly stricter rules when it comes to taxation.
This is because all contributions are made with pre-tax dollars, meaning that they get taxed when you withdraw the money during retirement.
With 401(k) plans, you can avoid taxation on contributions and earnings by rolling over your account to an IRA upon retirement.
The Bottom Line
Both types of plans offer significant benefits when it comes to retirement savings, but each plan also has its own pros and cons.
The differences between the two plans make it clear that one might be better suited for your needs than the other.
If you work for a state or local government, or a tax-exempt organization, 457(b) plans might be the better option.
Otherwise, 401(k) plans offer more flexibility and could end up being the better choice for your retirement savings.
401(k) Plan | A Complete Beginner's Guide
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
Pension vs 401(k)
Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.
How Much Should I Contribute to My 401(k)?
Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.
Plan in Advance
401(k) Plan FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.