457 vs 401k: How Do They Compare?

When saving for retirement, you may have the option of choosing between a 401(k) and 457 plan. Both retirement plans are IRS-sanctioned, and they allow participants to contribute pre-tax money that grows tax-free until when it is withdrawn. Participants only pay taxes on the amount withdrawn prematurely or after attaining retirement age.

The main distinguishing factor between 457 and 401(k) is how the retirement plan is offered. 457 plans are common in government entities such as state governments, as well as non-profit organizations. In contrast, 401(k)s are offered by private companies to their employees. These retirement plans also differ in other aspects such as withdrawal penalties, employer’s match, catch-up contributions, and rollover options.

How Does 457 Work?

A 457 plan is a non-qualified plan that is offered to state and local government employees. The participants may comprise firefighters, county employees, law enforcement officers, and public school teachers. Certain non-profits may also offer 457 plans.

Most of the time, employees are entirely responsible for saving for their retirement. Employers can match employee’s contributions, but most choose not to. Instead, contributions are deducted from the employee’s paycheck and held in a tax-deferred retirement account.

457 contribution limits are similar to 401(k) limits. For 2020 and 2021, IRS allows contributions of up to $19,500 through elective deferrals. 457 plans also allow catch-up contributions of an additional $6,500 in 2020 and 2021. This increases the annual contribution to $26,000.

An employer can also designate the employee’s 457 plan as a Roth account, which is funded with after-tax dollars. This means that the employee will pay taxes on the contributions, and the contributions made will not be deductible. Instead, the employee will not pay taxes on withdrawals in retirement

How Does 401(k) Work?

A 401(k) is a common retirement plan for employees working in private companies. The salary deferral limits for 401(k) are similar to 457 limits. Workers can contribute up to $19,500 in 2020 and 2021, and there is a catch-up contribution of an additional $6,500 in 2021 for those aged 50 or older.

Unlike a 457 plan, most employers who offer 401(k) plans also offer matching contributions to help employees save more. The employer determines the percentage of the employee's income to match, up to a certain portion of the salary or dollar amount. For example, if your employer offers a 100% match on all contributions made to the 401(k) account up to 3% of your income, a $70,000 annual income will give you an employer match of $2,100.

A traditional 401(k) allows contributions to grow tax-free, and any contributions made to the plan are deductible from the annual taxable income. However, an employee will be required to pay income taxes on early withdrawals or distributions in retirement. There is also a 10% penalty tax for withdrawals made from attaining 59 ½.

Key Differences Between 457 and 401(k)

Withdrawal penalties

If you make an early withdrawal from a 401(k) plan i.e. before age 59 ½, the withdrawal will be subject to a 10% penalty on top of the regular income tax you pay on withdrawals.

In contrast, 457 plans do not subject participants to a 10% for withdrawals made before age 59 ½. Participants are only required to pay ordinary income taxes. If you quit your job, you can start taking penalty-free withdrawals even if you are below 59 ½.

Employer matches

401(k) participants may receive an employer’s match of up to 100% of their annual compensation or $38,500 for 2021, or a combined employee and employer contribution of up to $58,000 as of 2021.

However, this may be different for 457 plans, since the government may not offer a contribution match for its employees. Usually, state and local government employees are eligible for pension on retirement, and 457 plans are treated as an additional savings plan.

Independent contractors

If an independent contractor is contracted to provide a service by a state or local government entity, they may benefit from the entity’s 457 plans.

However, independent contractors are not eligible to join a 401(k) plan since the latter only enrolls employees who have at least one year of service in the employer’s company. While you can still join a 401(k) plan without an employer, independent contractors providing services to a private employer do not automatically qualify to receive the 401(k) benefits.

Catch-Up Contributions

While both 401(k) and 457 plans allow catch-up contributions, 457 plans have a double limit catch-up contribution to compensate for the years not contributed. Participants can contribute the lesser of the regular annual limit or twice the annual contribution i.e. $39,000 as of 2021. Under the right conditions, participants can contribute as much as $39,000 in 2020 and 2021.

401(k) plans only allow participants to make additional contributions of up to $6,500 to compensate for the period they did not contribute. Participants do not benefit from the double catch-up provision, as is the case with 457 plans.

Rollover Option

When an employee leaves the employer for another company, he/she can decide to rollover the 401(k) into another 401(k) plan or an IRA. If the 401(k) balance is more than $5000, they can also choose to leave it with the employer indefinitely, before moving the funds to an alternative retirement plan.

For 457 plans, rollovers are only available to workers enrolled in a government 457 plan (PDF). When you leave your job, you can transfer your funds to the new employer’s 457 plan or traditional IRA. You can choose to rollover the funds directly to IRA, or withdraw the 457 account balance and deposit the funds into an IRA account within 60 days.

However, a non-governmental or private tax-exempt organization have more restrictions, and you cannot rollover the funds to a traditional IRA. Instead, 457 participants can either leave the assets with the employer, take a distribution, or transfer the funds to another non-governmental plan.