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:
Here are the referral links for the credit cards we currently use:
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?)
Final Thoughts
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!)
Yours in FIRE’d Frugality,
Ed
p.s. Please don’t be that non-saver guy in the tables. What a dingleberry!
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Wow, I did not even know these plans existed. They sound like they might be a good idea. I’m always looking for a good retirement account, since an IRA is not a good option for me within my specific financial situation. My employer does not have a 457, but my wife’s might. Thanks!
Miguel,
We’ve loved our 457 plans so much so that my wife and I refer to them as “millionaire makers.” I sure hope you wife has access to this invaluable account. If your wife is a school teacher or government employee, there is a good chance that she has a 457 option. If so, it’s hammer time! Good luck, Ed
Excellent post. In terms of good 457 plans, Alabama actually has a pretty good one available for educators along with a decent pension plan. The best choice is a SP 500 index fund with no “no administrative, membership, investment, transaction, sales or commission fees for participating fees.” They don’t advertise what fund it is, but the Boglehead forum indicated it was VFINX.
Dustin,
Great piece of information for my Alabama friends and readers. VFINX has an expense ratio of .14%…we can certainly live with that! Thanks for the data point. Ed
Thanks to Ed, I encouraged my wife to max out her 457 this year. We are behind this year so we were not able to also max out the 403b. However, even with this advice we will have deferred
$18000 in 457 money
$3100 in 403b money
for me, $18000 in TSP money. I figure by the end of the year we will be at $39,1000 deferred. This should lower our taxable income below the limit(I think its around 90k magi) and so the plan is to both contribute another 5500(total $11000) bringing us to deferred savings of $50,100!! It’s still not the 50% savings goal I wanted but it’s darn close. Next year I hope to max out everything…too bad that this year we missed an opportunity to save another $15k on her 403b.
One thing that I never thought of is if you have to leverage one person’s salary because of the access they have to 457, you may even want to rethink who is paying for health insurance. In our case, we were on her health insurance which actually made it difficult to max out both tax vehicles because she doesn’t make as much as me and so there wasn’t much left in the paycheck. In the future I may put health insurance on my salary(larger) so we can more easily max out tax savings on her paycheck(our tax savings as we file jointly)
I just wanted to tout an example of someone who learned from Ed! In our case we have the potential to sock away $70k in deferred income–something I never knew until I started reading this blog. MadFientist really helped me appreciate the power of tax deferred.
Lucas, you pathetic loser…you’ll only save $50k this year and fall below your goal of a 50% savings rate! Well, on second thought if you’re gonna fail, you might as well do it a la Lucas. Way to fail brother!
Great point on the coordination of healthcare benefits. At our last job, I took care of the health insurance while my wife carried the dental and vision insurance. We did so to make sure there was a enough money to max out all of our accounts. We take a team approach to our finances to best optimize our savings; it sounds like you two do the same.
It always makes me feel good to hear people are learning something from my posts. I think every teacher, policeman, fireman, and government employee should be a millionaire. The tools are there, and we just need to show them the way. Keep it going “loser!” Ed
haha I will be a rich loser thanks to you! Ed…I have a question for you. After reading Gocurrycracker he agrees with you that all tax deferred savings should be maxed out even before Roth contributions. My question is…is there any value in Capital gains savings at this point? Like I said it looks like we have about $70k of tax deferred space. We will be lucky to hit that number and wouldn’t be able to do any capital gain savings after that. Do you think we should diversify a bit or hit as much tax deferred stuff as possible? I am just trying to stay cognizant of the fact that we will pay ordinary income on these contributions at some point(as opposed to the cap gains rate)
That’s a good question because at some point you’ll have a whole bunch of money waiting to come in as ordinary income. Here’s what we’ve done: First, we take $18,375 in 72t IRA distributions. These distributions are covered by our 2017 Free Money + 10% income limit of $43,500. This leaves us $25,125 of room to do a Roth Conversion. Truth be told, if I had it to do over, I would have held off on the 72t distributions because we have to take them until the age of 59.5. That would have allowed a bigger Roth Conversion space. At any rate, you could use a Roth IRA Conversion ladder to turn all that taxable ordinary income into Roth moolah. You wouldn’t have to get all converted, just enough to keep your tax rate low.
I guess the ideal situation is to 1.) have ordinary income that falls in the Free Money range, 2.) a good chunk of tax-free Roth income, and 3.) a nice taxable account that has 0% capitals gains due to your total income remaining in the 15% tax bracket. I’m working on the #2 money right now: we did a $30k conversion last year and we’ll do a $20k conversion this year. We almost have $9k in our taxable account; VTSAX is right around the corner!
The worst case scenario for me is that I’ll have to pay some tax at the 15% rate. If our IRA accounts got really big, we’d consider opening a charitable trust. I’ll have to bone up on that first. I’m still trying to figure this out myself.
Thanks Ed. Sounds like you think it’s ultimately best to max out every tax deferred dollar first. Hopefully some day we can make it to a cap gains account but I guess worse case scenario we just would need to draw that 457 money with in the “free zone” or yea pay a little tax on it.
Great post. For some a 457 can allow you to harvest free capital gains in your taxable account which is such a bonus. Maybe not a #8 since everyone can’t do it, but its awesome. With my 457 you really have to watch the fees. There is one Large Cap (S&P500 benchmark) fund with fees of 0.1320% and one bond fund with 0.1316%. The admin fee is 0.129%. So my total fees are approx 0.26%. I can live with that, but if you pick other choices then fees can be much higher.
Thanks Mr. Wheat. Does a 457 make free capitals gains possible by reducing total income to the 15% tax rate? Yes, yes, yes to the fees comment. I see variable annuities all the time, so I see the worst of the worst. Ed
Yes for us it reduces income enough to harvest significant FREE capital gains. Harvesting gains is a bit complicated due to the way it stacks with other income and deductions. Michael Kitces has a nice article on how it stacks. I found that I could only estimate what I could harvest for free using tax software. I used last years return and adjusted for this years estimates.
Hello Millionaire Educator
I am an avid reader of FI blogs. I am looking for a resource which points me to one of the best places in the US to retire from tax and cost of living perspective. To be specific, I would prefer to pay minimum state taxes on my retirement withdrawals and also minimal property taxes. Of course, cost of living has to be in check as well. What I don’t mind is sales tax because we are a low consumption household. Can you point me to a blog/article from the FI community which talks about this?
I understand that during retirement, I can convert a small portion of Pretax money in 401K/IRA to Roth each year and that will prevent overall taxation but I am looking for more US state specific information instead of the taxation hacks which I am already aware of.
Thanks
Vishal
Vishal,
It appears that we might be sharing the same brain. I find myself thinking of such optimization ideas all the time. A few good website to play with are:
If I were to pick a state based solely on its no income-tax status, low property tax, and overall low cost of living, I would look at: rural and small town Tennessee or rural and small town north Florida. Tennessee seems like an awesome choice since they are in the process of phasing out the Hall Tax (the tax on dividends and capital gains) over the next four years.
North Florida might work for you too, especially if you pick up an inexpensive home ($50k or below) and make it your homestead. You’d only pay school tax on such a home with no property tax. However, Florida homes that do not have the homestead exemption pay “full freight” if you know what I mean. Florida has mild winters, but I can’t discount those hurricanes.
I used to be interested in Texas, but it seems the property tax there can go sky-high depending on the municipality. That aside, Texas is an awesome place to us. I hope this helped. Please share anything you learn regarding super efficient tax locales. Thanks for the question, Ed
I am lucky in that I have access to a 401a (notice not 401k), 403b (I max) and a 457. However, I haven’t started funding it yet. I need to start doing that, even if it is $50 a paycheck.
“The journey of a 1,000 miles begins with the first step,” so YES, start a trickle into that 457 when you can. Fund your freedom!
Hi Ed,
I’m a police officer and my wife is a teacher. We’ve been doing exactly what you described in this article and were 3k short of 1.5MM.
You are absolutely correct! Funding these to the max will eventually make you a millionaire. Along with LBYM of course.
We front load my 457 and my wife’s 403b and 457 so that they are fully funded by April 1st. And we draw down off a taxable account to fund our living expenses for the first three months.
I urged my Village officials for years for a 457 and I was granted not only a 457, but a low cost one- Fidelity which I nearly begged them for.
In place of the usual high cost vendors that serve municipalities such as ICMA and Nationwide.
I did the same at my wife’s school district and even got a petition signed by other teachers for the purpose of getting a low cost 457 vendor. The only choice was AXA!
Fortunately, they have Vanguard for their 403b.
So we were able to secure Aspire for the 457 vendor. I too realized how beneficial 457’s were with the added benefit of the no age restriction penalty.
However, I would like to inform others that the way Aspire is advertised- at least at my wife’s school district is very misleading.
At my wife’s district and I suspect at others, Aspire is listed with the names of 10 Financial Advisors next to it, from Edward Jones.
This would make one believe you needed to get “serviced” from Edward Jones in order to participate and YOU DO NOT!
I learned by accident while speaking with an Aspire rep that we could do a “self-directed” 457 plan with Aspire and NOT need Edward Jones.
So when we filled out Aspire’s paperwork, we simply wrote in “self-directed” where they asked for a salesman’s, I mean Financial Advisor.
We selected the fund we wanted to invest in, Vanguard Total Stock Market and continued to fund it annually.
54K in those three accounts, plus 11k in our Roth IRA’s and now were contributing additional money in our taxable account at Vanguard using VTSAX as well.
I hope others learn that if they have shitty 403b/457 options but happen to see Aspire, know that with a self-directed account, that will be as close to Vanguard like fees that you will get.
Were blessed to have Vanguard and Aspire for her and Fidelity for mine.
Keep up the great work!
Nicely done Charles! Yes, we also signed up for Aspire in Douglas, GA, and there was a lot of confusion. I do remember that we opted for the “self-directed” option and did all of the investing ourselves. I also remember a number of screw-ups and hassles when I rolled our 457 money to Vanguard, but eventually it got there. I also believe there is a lot of intentional confusion on 403b-457 provider lists because when employees think that “full service” is their only option, vendors, middlemen, and advisors get charge fees on your assets under management. It’s quite a scam; I view it as legalized theft. Any way, great job by you and your wife! Ed
I need some help! My husband and I are both in education. He has aspire for 403 but not 457. I’m reading a ton, thinking about index funds but not sure where to start. Thanks!
Hi Nicole,
What are his 457 options? Don’t forget that he can always open an IRA at Vanguard; you can too if you have income. Vanguard requires $1k to open a Target Retirement fund or $3k for other mutual funds. Email me if you need more input. Best of luck, Ed
Hi Ed,
I believe my wife’s job has a unicorn 457 as you described above. She has the option to invest in BKTSX (iShares Total U.S. Stock Market Index K) which has gross/net expense ratios of 0.06/0.03%. The plan has a footnote next to the expense ratio which states the following: “The Fund has a Contractural Expense Ratio Waiver in the amount of 0.03% which expires on 30-NOV-2019”. Wanted to get your opinion on the quality of the 457 plan and if you agree that this is the unicorn of 457 plans.
Hi Dylan,
It looks like you have a cost-effective 457 option…for now. I’d keep an eye on what happens in November because the financial services industrial complex lost the benefit of the doubt with me years ago. As a teacher, I always expect and assume the worst since the K-12 marketplace is often a disaster. Keep me posted on how it goes. Best of luck, G
I have a 457 Plan that comes from the state of Maine, and then a third party directly manages it. There is a quarterly fee of $12.50, and it’s all Vanguard funds. I didn’t realize just how terrible these plans are elsewhere–it makes me so much more thankful for the one I do have!
Sam,
Consider yourself fortunate! Whoever put your plan together knew what they were doing. It sounds like your plan benefits you and your co-workers. Vanguard funds with an administrative fee of $50 a year is awesome in the K12 403b world. Best of luck working your plan and enjoy your summer, Gerry
Hi Ed
My name is Marc and I stumbled upon your website when I asked the Choose FI community in FB on their thoughts on 457 plan. Great website with awesome information by the way! So, Im new to financial world and not as savvy as others but Im learning. Im 36 yrs old, single, no house/car/school loan payments and just rent. I work in hospital as a registered nurse and we have 401, 403 roth and new 457. Im just lost in terms of how much should i contribute in which. So to put it in question, should I max 457 first then roth 403? I just want to take full advantage of this millkionaire fund 🙂
Another question is where do you get your monthly bill payments if you and your wife max your reitement funds? you probably illustrated it already. My apologies.
Thank you,
Marc
Hi Marc,
It’s awesome that you have few bills and many retirement plans! From my perspective, you’re sitting in an enviable situation. If you’ve read any of my posts, you know that I’m partial to the 457 plans due to their lack of pre-59.5 early withdrawal penalties. That said, you need to decide how YOU’LL use your 457: will you invest in it or will you use it to park money until you need it in the near or distant future. Also, what are the investment fees associated with your 457 plan; make sure you understand those fees before you start investing in it. Also make sure that there are no load fees or surrender charges.
As for 403b, I’d fund that too if I had the means. I’d use the Roth 403b account only to the extent that it didn’t raise my income tax obligation. In other words, I’d use the regular 403b to dramatically reduce my tax bill, but that’s just how my reptilian brain works. If you still have money to invest, don’t forget to fund your IRA and HSA accounts. Those four tax-advantaged plans can reduce your taxable income while ramping up your savings rate.
How do we pay our bills? Thanks for reading and best of luck working YOUR FIRE plan. Gerry
Hello Ed,
Thanks for the interesting content! After looking into the 457b plan offered by my hospital, the funds offered seem reasonable but the portability seems to be very different than the 457 plan you described above. The wording in my plan specifically states upon severance: “You also have the option to leave your money in your Plan or cash out. If you cash out, the distribution will be subject to income tax. Your Account may NOT be rolled into a 403(b), 401(a), 401(k), or IRA.”
Considering my plan is not able to be rolled over to an IRA, would you still consider this to be a good plan for retirement? I am currently maxing 403b, HSA and Roth IRA.
Thanks!
Sam
Greetings Sam,
That is the first 457 plan I’ve ever heard of with that limitation. Who is the provider? Next question, could you “cash out” over time and simply take the money as needed? If so, all of you income at a new job could be funneled to your tax-advantaged accounts. GB
Does the distributions from your 457 and 72Ts count as normal income? Or are they taxed like long term capital gains?
Thanks for the wonderful posts, we are learning so much!
Hi Steph,
Those distributions come in as regular income. That’s why having a tax plan is so important. Like most of my readers, I don’t like tax surprises on April 15th! G