Saluton al ĉiuj miaj milionoj da legantoj! If you’ve heard any of my podcast interviews (#1, #2, #3), you know how much I love my 457 plans, even my fee-bloated variable annuity 457 plans. Here’s my list of why you should love your 457 plan:
1. Contributions Are Tax-Deductible
The first thing to love about your 457 contributions is that they are TAX-DEDUCTIBLE. This means that you can legally subtract your 457 contributions from you taxable income. Why would the government allow you to put money in a 457 account and not pay tax on it? Simple, the government would prefer to have retirees with retirement saving as opposed to destitute retirees on the government dole.
Here’s an example of two individuals who both earn $50,000 a year. One saves nothing while the other saves $10k in his 457 plan. Because the non-saver contributes nothing to his 457 account, he pays income tax on his entire $50k of income. Plus, he has saved nothing for his retirement. Meanwhile, the saver not only manages to save $10k for his retirement, but he also reduces his taxable income by $10k. Check out the example below:
2. Contributions and Earnings Are Tax-Deferred
Another reason to love your 457 account is that your contributions and their earnings are TAX-DEFERRED. In other words, you won’t owe any tax on your 457 funds until you take distributions in retirement. Let’s say you decide to invest $10k in your 457 for five years. First, you would shield $50k from federal and state income tax. Of course, Uncle Sam will expect to get his cut when you start pulling your money out in retirement. (That’s not as bad of a deal as it sounds because most people will be in a lower tax bracket once they enter retirement.) Second, the return on your money also is exempt from income tax until retirement. For example, if your annual 457 contributions grew by 7%, your return would be $11,533 resulting in a total balance of $61,533. See the calculation below:
Keep in mind, that at the end of five years you would have 1.) amassed over $61.5k in your 457 account and 2.) greatly reduced your taxable income. Putting lots of money on your side of the ledger while simultaneously stiff-arming Uncle Sam is a beautiful thing. Here’s how a non-saver and saver compare after saving $10k for five years:
3. Contribution Limits Are Substantial
If you like the thought of saving $10k a year, you’ll be happy to hear that you can save even more in your 457 account. As of 2017, the maximum 457 contribution limit is $18k a year. Individuals age 50 and over are allowed to make an additional catch-up contribution of $6k a year. So, mature adults such as myself can save up to a whopping $24k a year. (Hey, I’m from a working-class background, so $24k is a lot of money to me!) Take a look at these maximum savings examples:
4. You Can Contribute the Max to Both a 457 and a 403b/401k
Okay hotshot, you’ve crushed your 457 savings by contributing the maximum for the year. But for you $18k (or $24k potentially) is simply not enough and you want to keep on hammering your hardcore savings. The good news is that your 457 contributions are not coordinated with your 403b or 401k contributions. Do you understand what this means? You effectively have two “401k” accounts! In other words, you can contribute $36k ($18k x 2) to your 457 and 403b/401k accounts. Now if you’re in hardcore savings mode, this is an awesome financial advantage that most private sector employees DO NOT have. Take a look at the example below:
(Interesting note: your 403b and 401k contribution amounts ARE coordinated. You cannot contribute $18k to both a 403b account and a 401k account in the same year.)
5. An Enviable Tax Planning Tool
Alright maybe my example in point #4 is too ambitious for you in your present financial situation. I understand because I wasn’t always the Millionaire Educator; I used to be Mr. Month-to-Month myself. However, let’s assume that you (a single person for this example) read some of my tax planning posts (#1, #2) and decided that you wanted to keep your federal income taxes within the 10% range. After a few basic calculations you determine that you can earn up to $19,725 in 2017 before you hit the 15% income tax bracket. (If calculations are not your thing, I’ve already done them for you here. You’re welcome!)
From there, you fully fund your 403b, traditional IRA, and HSA accounts for a total savings of $26,900. While you’ve done a great job, you still have income in the 15% bracket because your taxable income is $23,100 ($50k – $26.9k). Thanks to one of my 457 posts, you suddenly remember that you have access to a 457 plan. Great, but what to do? Easy peasy, you contribute $3,375 to your 457 account and thereby reduce your taxable income to your magic number of $19,725. While you did not fully max out all of your accounts, you did a good job of minimizing your tax obligation. Two high-fives! Hey table addicts, check it out below:
Effective Tax Rate of 4.73%! ($933 / $19,725)
6. After Separation of Service, You Can Roll Your 457 Funds to Greener Financial Pastures
Okay, this is an unpleasant topic for me, but here goes. Most public school educators have inferior 457 plans due to their astronomical fees. Why are they so expensive? Well, that’s an easy question: such plans almost always use variable annuities. On average variable annuities charge 2.25% a year in fees while my Vanguard VTSAX mutual fund charges a minuscule .04%. Let’s see, 225 divided by 4 equals 56.25…so, your typical variable annuity is 56 times more expensive than my cost-effective Vanguard mutual fund. Wow, that really sucks big time! But, don’t despair because there is a way around this problem.
In all our years of teaching we have only had one decent 457 plan, Aspire Financial Services. Usually, we had fee-bloated variable annuity plans that we refused to invest in due to their fee structure. Instead, we decided to use our 457 plans TO SAVE IN ONLY. As long as the 457 plan did not have surrender charges, we would contribute money to the plan’s fixed value account (similar to a savings account earning 1-3%). We always knew that at some point we would leave our jobs (i.e., separation of service) so that we could roll our 457 and 403b plans to our Vanguard traditional IRAs. If you have a high-cost 457 plan, you can roll your 457 funds to the following accounts:
- Traditional IRA * You can roll your 457 funds tax-free to an IRA, but be aware that those funds will then be treated just like IRA money. (If you rolled your 457 money to a Roth IRA, that would be a taxable event.)
- Another 457 Plan * If you have the good fortune of getting a new job with a cost-effective 457 plan, you can roll your 457 funds to your new plan without any taxable implications. This sounds great in theory, but I don’t know any teachers who have taken new jobs with a decent 457 plan. (It’s kind of like a unicorn hunt.)
- A 403b or 401k Plan * If you take a new job that offers a 403b or 401k, you can roll your 457 funds without causing a taxable event. However, 457 funds will then be treated like typical 403b or 401k funds.
In 2016 we rolled $48k of 457 funds to our Vanguard rollover IRAs. Usually, we prefer to leave our funds in our old employers’ 457 plans. Why? Well, that leads to my final reason…
7. After Separation of Service, 457 Funds Have Special Tax Treatment
Here is my favorite aspect of the 457 plan: unlike 401k, 403b, or IRA accounts, 457 plans do not impose a 10% penalty on withdrawals taken prior to age 59.5. Wow, this is awesome because it means that when you quit your job, you can begin taking 457 distributions without penalty. Keep in mind that these 457 distributions will be taxed as regular income, but that shouldn’t be a problem with a little tax planning.
Because 457 funds become accessible after separation of service , we view our 457 accounts as our “freedom funds.” Since we can pull money from our 457 accounts as needed to cover living costs, we are then able to save 100% (or close to it) of our income from our jobs. In short, we live off our 457 plans and 72t distributions while we max out our 457, 403b, IRA, and HSA accounts. Having access to 457 funds also eliminates our need to maintain an emergency fund.
Let’s take a look at how we use our 457 funds after we quit our jobs. Every year we determine how much income we’ll take out depending on our “Free Money! + 10%” amount. For 2017, we could earn $43,500 before we entered the 15% tax bracket. We have three main sources of income: our yearly 72t IRA distributions of $18,375, our 457 distributions, and the remains of our paychecks. You’ll see from the first part of the table below that we are able to generate enough income to reach our goal of $43,500.
This Enables Us to Go into Hardcore Savings Mode at Our Jobs (see below).
The second part of the table illustrates what we do with our paychecks when we no longer need them to cover living expenses. As you can see, we cram the maximum contribution amounts into our 457, 403b, IRA, and HSA accounts. While the table shows that we have over $17k of income left from our paychecks, it does not reflect GA TRS pension contributions (roughly $8k and tax-deductible) or Medicare taxes (around $1.8k but not tax-deductible). That means that the remains of our paycheck might even be lower than $10k. In that case, we could take a little more for our 457 accounts as needed.
Important note: Before you roll your 457 funds over to an IRA, 403b, or 457 plan, you might consider simply leaving the money in place with your former employer. Why? Because once your 457 money is rolled to a non-457 account, it loses its magical 457 status (remember that part about no 10% penalties for withdrawals before 59.5?)
I realize that some of my points cited in this post are pretty basic for my more advanced readers, but many of my readers still need to learn the basics. Just remember that a 457 plan can help you supersize your savings, minimize (or eliminate) your taxes, and provide you with a stream of income once you quit your job. For those reasons, the 457 plan is my absolute favorite retirement account. If you have any questions or comments, I’d love to hear them. (Oh, almost forgot to mention that this is the first time I ever worked an Esperanto phrase in a post!)
p.s. Please don’t be that non-saver guy in the tables. What a dingleberry!
|Health Savings Account: We use Elements Financial to access commission-free, low-cost Vanguard ETFs at TD Ameritrade.