Pros and cons of government 457(b) retirement plans

Like its better-known sibling — the 401(k) — a 457(b) retirement plan is a tax-advantaged way to save for retirement. But the 457(b) is designed especially for employees of state and local governments, as well as a few tax-exempt organizations. (If you’re employed by the federal government, however, you have access to a thrift savings plan rather than a 457(b) plan.)

The 457(b) retirement plan offers many advantages to government workers, including tax-deferred growth of their savings, but these plans do come with some drawbacks. Here’s how the 457(b) plan works and what you need to watch out for.

How the 457(b) plan works

A 457(b) is similar to a 401(k) in how it allows workers to put away money into a special retirement account that provides tax advantages, letting you grow your savings tax-deferred.

“It’s very similar in that you can only defer a certain dollar amount each year, and the amount you can defer is linked to the cost-of-living (indexes), as the 401(k) is,” says Dominick Pizzano, a New Jersey-based employee benefits consultant at Milliman, an actuarial and consulting firm.

The employee contribution limit is $23,000 for 2024 for workers under age 50, which is in line with 401(k) contributions. Also similar to the 401(k) is one of the catch-up provisions that allows workers aged 50 and up to contribute an additional $7,500 each year.

And like the 401(k) program, which has both a pre-tax and after-tax Roth version, 457(b) plans may also offer these two flavors of the retirement plan.

The major difference between the two? The pre-tax 457(b) plan allows you to contribute money and take a tax deduction today, and then at retirement you’ll pay taxes when you take money out of the account. In contrast, the Roth 457(b) allows you to put in money after-tax – paying taxes on the contributions today – but you won’t have to pay tax on withdrawals at retirement.

A key difference in 457(b) plans

Now for the curveball: 457(b) plans also may allow workers to save extra money starting three years before the “normal retirement age,” which is specified in the plan. The normal retirement age can vary, but the special contributions can begin three years before that point.

“So if someone was to retire at [age] 50, they could begin the 457 catch-up at 48 because it’s three years prior to their retirement age. It’s called the three-year rule,” says Julia Durand, a former director at CalSTRS (California State Teachers Retirement System).

Here’s the deal: during each of the three years employees can contribute twice the normal elective deferral limit or the sum of the current year’s ceiling plus unused portions from prior years, whichever is less.

For 2023, that maximum contribution could be $46,000 or $23,000 plus the sum of all the money you didn’t put in but could have in previous years, whichever is less. (The latter choice is available only if you’re not using catch-up contributions for being age 50 or over.)

The formula sounds a bit convoluted – and it can be that way on the administrative end as well. That’s why plan administrators sometimes choose not to offer it as a catch-up option.

“It requires information to calculate that the employers may not always have available to them. If an employee wants to participate in catch-up, they have to provide the payroll records that show they did not contribute the full amount they could have for past years,” Durand says.

Employer matches for 457(b) plans are rare

State and local government employers rarely provide matches on 457(b) plans to employees. With 401(k) and 403(b) plans, the annual contribution limit applies only to employee deferrals, not any money “matched” by the employer. However, if a government employer does make a contribution to a 457(b) plan, it counts toward the total allowable limit for the year.

For instance, if a local government employer contributes $1,500 in 2024, the employee may contribute only $21,500, keeping the plan to the $23,000 annual limit. However, a government employer could theoretically kick in the entire yearly limit if it wants.

Since many government employees already have a pension, a defined contribution plan such as a 457(b) is considered a supplemental savings plan, so an employer match is uncommon.

“The 457 plan doesn’t have a match, and it doesn’t really sell itself,” says Andrew Ness, a former consultant at Mercer Investment Consulting.

Fees for 457(b) plans may be higher

Since government employers don’t usually lure workers into the 457(b) savings plan with free money, they may sign up for services that end up costing participants a little bit more but will encourage them to save.

“What is seen more commonly in the 457 market that isn’t as prevalent in the 401(k) market is an on-site education representative model — so, having people physically visit to educate employees and enroll them in the plans,” Ness says.

Bringing in representatives can drive up plan participants’ fees. But there are other factors that influence the cost of 457(b) plans to workers, such as the size of the plan.

Similar to the corporate world, larger plans have more leverage than smaller ones to negotiate fees.

“Providers need to have a little bit more profit margin to service the small plan, so the fees are probably a little bit higher in those plans,” Ness says.

The plan administrator also can make a difference. “Some 457s offer more competitive fee structures than 401(k) plans and vice versa,” Durand says. “It depends on who’s at the helm and if their fiduciary responsibilities are taken seriously.”

Withdrawals from 457(b) plans

When it comes to tapping into the account early, 457(b) plans make it harder to withdraw money in an emergency, though it may still be possible to take a loan, depending on the plan’s provisions.

To qualify for a hardship withdrawal, the funds must be not only for an emergency, but an unforeseeable one.

“In the 401(k) plan, if you needed money to buy a house or to pay tuition for a dependent, you could do that,” Pizzano says. “But in the 457 plan, those types of foreseeable withdrawals are not allowed. It has to be something catastrophic, like a fire without adequate insurance to replace your house.”

The 2022 SECURE Act 2.0 made it possible to access some of your funds without getting hit by the typical 10 percent early withdrawal penalty, however. Qualified circumstances include those who underwent federally declared disasters, survivors of domestic abuse, those with emergency expenses of up to $1,000 and those paying long-term-care premiums that begin three years after the enactment of the SECURE Act 2.0. Generally, withdrawals must be repaid within three years in order to avoid the money being taxed as income.

Finally, if your plan allows it, you can access some of your money via a loan. The maximum a participant can borrow is 50 percent of the vested account balance or $50,000, whichever is less. However, those with an account balance less than $10,000 may borrow up to 100 percent, if the 457(b) plan allows it. The loan must be repaid within five years, and the participant must make payments on the balance at least quarterly.

Early distributions from 457(b) plans

The good news is that distributions to workers who retire early are less taxing. Early distributions, those before age 59 ½, from 457(b) plans are not subject to the usual 10 percent penalty if the employee has separated from the service of the plan’s sponsor. There’s a good reason for that, Durand says.

“Typically, police and fire departments were the participants in 457 plans for counties or municipalities. And typically, they would retire early on a disability,” she says. If the 457 plan didn’t have the exemption for early distribution, those workers would have been penalized and unable to access money that they needed.

But while penalty-free early distributions allow flexibility, they could be a double-edged sword, since they allow workers to spend money that could be saved. Keeping the money invested in a tax-sheltered account as long as possible is nearly always the best option for building wealth.

Bottom line

When it comes to defined contribution plans, the 457(b) has more in common with its corporate counterpart, the 401(k), than it has differences. But those key differences are significant, and investors need to pay special attention if they have both kinds of accounts.

And even if you have any of these accounts, you can still open an IRA, which provides still further retirement benefits. The Roth IRA might be the most powerful retirement account in the U.S. – here’s how to open a Roth IRA and what you need to know.

— Sheyna Steiner contributed to the initial version of this story.