457 vs. 401(k) Retirement Plans: Breaking Down the Pros & Cons of Each
As a medical professional, you likely want to know the best types of retirement funds you have at your disposal. A 401(k), one of the most popular types of workplace retirement plans, might be in the cards, but what about other options, such as a 457? Let’s take a look at a 401 vs 457 to get an idea of which option may make sense for your particular situation.
We’ll discuss the definitions of a 401(k) plans and 457 plans, as well as the pros and cons of each. When you finish reading, you’ll hopefully have a taste of the type of plan that may help you pave your future.
What is a 401(k) plan?
A 401(k) plan is a workplace retirement plan that allows you to make annual contributions up to a certain limit and invest that money toward retirement. Both employers and employees can contribute to a 401(k) plan. Employee contributions reduce your taxable income and earnings grow tax-free until you take them out in retirement.
The amount individuals can contribute to their 401(k) plans in 2023 is $22,500. Participants who are age 50 or older can contribute an additional $6,500.
An employee indicates a percentage of income that they want to have automatically taken out of each paycheck and put into an account. Employees can choose to have their money invested either before or after tax, depending on the options offered in the plan.
You may not automatically be vested in your employer’s retirement plan. Retirement plans depend on vesting — the amount they own in their plan each year. A 100% vested employee owns 100% of their investment. The employer cannot take the investment away from you for any reason.
You cannot take your money out of your 401(k) before age 59 ½ without paying penalties. If you withdraw money from your 401(k) before age 59½, the IRS usually assesses a 10% penalty when you file your tax return.
Pros and cons of 401(k) plans
Let’s take a quick look at the pros and cons of 457 vs 401. It’s important to consider them carefully because you want to make sure you choose the right type of retirement plan for you.
Pros of 401(k) plans
Cons of 401(k) plans
Earnings grow tax-free until distribution. This means that you don’t pay taxes until you withdraw upon retirement.
Must pay a tax penalty of 10% for early distributions (before age 59 ½)
You can make either pre-tax (those made before you pay taxes) or after-tax contributions (those you make after tax). After-tax contributions are those in a Roth 401(k). If you expect a lower tax rate in retirement, pre-tax contributions should be more advantageous. If you expect a higher tax rate in retirement, consider a Roth 401(k).
Limited investment options
Can take out loans against a 401(k), but you should only do so as a last resort.
May end up paying high fees
Employer matching common
Your plan provider may not help you make investment decisions.
Contributions reduce current taxable income, which means you’ll owe less in taxes, whether you itemize your taxes or take the standard deduction.
Employer matches may take a long time to vest. This means that if you leave your employer, you may leave before you’re fully vested — you may not stick around long enough to get the full 100%.
What is a 457(b) plan?
A 457(b) plan is a retirement account that allows government employees (including health care agencies) to contribute pre-tax dollars that grow tax-free until withdrawing them in retirement. The Internal Revenue Service (IRS) only allows state or local governments or tax-exempt organizations to establish 457(b) retirement accounts. They aren’t subject to the same regulations as other retirement plans.
You can lower your taxable income with a 457(b) plan and will pay taxes at ordinary rates when you withdraw your money.
Both employees and employers can contribute to 457(b) accounts, though the employer doesn’t have to do so and many choose not to.
You cannot withdraw funds from a 457(b) account while working for a plan sponsor. When you leave your job, you can take out funds without having to pay a 10% early withdrawal penalty common in other retirement plans. However, note that you will have to pay taxes on money that hasn’t been taxed before.
The contribution limit for a 457(b) is $22,500 for 2023 for workers under age 50. You can also contribute an additional $7,500 in 2023 if you’re 50 or older.
You can also invest extra money — twice the limit, or $45,000 — starting three years before the “normal retirement age,” in 2023. The amount of extra money you can vary depending on the organization you work for.
In many 457(b) plans, deferrals are fully vested when made.
Pros and cons of saving in a 457(b)
One of the best ways to decide between a 401(k) vs. 457 plan is simply by looking at the pros and cons of saving in a 457(b).
Pros of 457(b) plans
Cons of 457(b) plans
Assets grow tax-free, which means you don’t incur taxes as you save money in your account.
Only certain government employees can participate
You can make pre-tax contributions through a traditional 457(b) plan, in which you make pre-tax contributions that are taxed along with the earnings in retirement. Roth 457(b) contributions are made after tax and you do not get taxed when you withdraw your money in retirement. Both offer benefits, depending on whether you believe your taxes will be higher or lower in retirement.
Employers might not contribute much, if at all, to a 457(b) plan.
No penalty for early withdrawals
Employees may not know about the 457(b) as an option if the primary retirement vehicle is a pension.
Can borrow against the account, though it’s not recommended
Funds will incur tax penalties for early distribution if they are rolled to an IRA.
Employees at or over age 50 can make catch-up contributions.
Some 457 plans don’t allow rollovers to other retirement accounts.
Which option makes the most sense for your goals and investment objectives? If you’re not sure which option (or both!) will fit your needs, consider talking with a financial advisor. They will help you outline your goals and make a plan over the course of your career and in retirement.
