Should I Use My 457 to Invest?

Many doctors are high-income earners and will have access to a 457 plan.  Despite this, one of the more common questions I get is whether someone should use their 457 plan or not. It usually goes something like this, “Hey, Jimmy, I am looking to save a little more money and saw that I have a 457 plan. What are your thoughts on this? Should I invest in my 457 plan?” It seems like this should be an easy answer.  Unfortunately, that’s not the case. 

While a 457 plan has some great features  – like being able to use a 457 in early retirement without the 10% penalty a 401K experiences if utilized before 59 1/2 years old – whether you should use it or not is complicated. It’s just not as easy as whether or not you should invest in your 403(b) or 401K

If you are asking if you should use your 457, this is the post for you.

What is a 457 Plan?

Just like any other retirement plan, this comes from the part of the IRS tax code that bears its name.  In this case, that is section 457 for deferred compensation plans.  A “deferred compensation plan” allows you to make pre-tax contributions and will allow your earnings to grow tax-free while in place. You “defer” this compensation until some point in the future

There is an important distinction, though, and I am going to make it early.  There are two ways you can qualify for a 457. The first is that you work for the government and are provided a governmental 457.  The other way you can have access to a 457 is through a non-governmental employer, which grants you access to a non-governmental 457.

While the governmental and non-governmental 457s have some similarities, there are also some very important differences.  This post will help you sort it all out and give you a clear answer on whether you should use your 457 plan or not.

The following are some details that are similar to both a governmental and non-governmental 457 (NG-457) to help you determine if you should invest in your 457.

All 457 Plans Have These Features

For 2024, the contribution limit for 457 plans is $23,000.  For some over the age of 50, you may be able to contribute more (typically if within three years of the retirement age for your plan). Another feature of all 457s is that they may be transferred from one 457 to another (governmental to governmental; non-governmental to non-governmental).  However, the receiving plan must accept transfers.

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You must take distributions from your 457 by April 1st following the year of your retirement or by age 70.5 years old (whichever happens later).

Governmental 457s Versus Non-Governmental 457s (Reference IRS publication)

While some of the similarities discussed above do exist, governmental and non-governmental (NG) 457s also have some major differences:

 

 

Here are the major differences between governmental and non-governmental 457 plans from illustrated in the graphic above:

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  • Governmental 457’s may be rolled over to eligible retirement plans (i.e. Rollover IRA’s).  NG-457’s cannot be rolled into an IRA.

• • Age > 50 catch-up contributions are only available for governmental 457s.

• • NG-457’s are “Top-Hat” plans and must limit the number of people who can participate to “groups of highly compensated employees or groups of executives, managers, directors or officers.”

• • Governmental 457’s often allow Roth contributions. NG-457’s do not allow Roth contributions…otherwise, this would be a great way to avoid the possible tax consequences of bad distribution options, which are discussed more below.

• • This is the most important difference: Governmental 457s are backed by the US government (NG-457s are backed by individual institutions and are available to creditor’s upon legal action or bankruptcy).

On that last point, here is the exact wording from the IRS on non-governmental 457s:

“[Non-governmental] Plan assets are not held in trust for employees, but remain the property of the employer (available to its general creditors in the event of litigation or bankruptcy)….Employees are lower in priority than general creditors in the event of legal claims against the employer.”

To put this plainly, this means that if your institution goes bankrupt or litigation trouble, your hard-earned retirement money is available to creditors. Said differently, they can take that money and give it to someone else. This is very different from your typical 401K or 403B which is not only protected from employer litigation but often protected even in most personal litigation (i.e. medical malpractice cases).

Should I Invest in My 457 Plan?

There are certain tax benefits associated with participating in a 457.  This includes being able to contribute pre-tax money to decrease your overall tax burden.  The gains also grow tax-free.  Your only taxation occurs when you take it out.  This is similar to your standard (pre-tax) contributions to a 401K and 457.

If you have a governmental-457, this is backed by the government.  If the government defaults, the entire global economy will collapse.

This provides some comfort for those with a governmental 457.  In fact, I would argue that you could view a governmental 457 as a second 401K or 403B.  It’s just as safe and provides many of the same benefits. Congrats, if you have one!  Don’t think twice. Use it.

For example, my wife was previously employed as a full-time educator. So, while she had access to a 401K, we preferentially placed our pre-tax investments into her governmental 457, which can be used in early retirement, unlike a 401K.

Non-Governmental 457’s Are Not the Same: What You Should Consider

We have already highlighted some of the differences between a governmental and a NG-457s. If you have a governmental 457, go contribute if it has good investment options. It really is that simple.

On the other hand, If you have a NG-457, you need to make sure your specific plan doesn’t have the following three problems before participating.  Going step-by-step through this will help you answer whether you should invest in your 457 or not.

Remember, you are comparing investing in a NG-457 to a taxable/brokerage account where you’ll be paying taxes on the gains.  So, if any of the following steps look problematic, I’d recommend you consider investing in a taxable account.

Step #1: Employer/Institutional Finances

Remember, your NG-457 money is available to creditors. Combine this with the fact that most of us do not have inside information on our employer’s financial situation, it makes for an uncomfortable and potentially sleepless situation. 

Before you contribute to your NG-457, you should be intimately familiar with your employer’s financial situation.  What’s their bond rating?  How much cash on hand do they have?  Have there been any recent changes that would lead you to believe there are financial troubles?

If so, it is time to avoid your NG-457 plan. If you feel that your employer’s financial situation is healthy as a horse, then proceed to Step #2.

Step #2: Check the Distribution Options

Distribution options are sometimes terrible inside of a 457.  You cannot contribute via Roth to non-governmental 457s. Therefore, if your distributions are less than optimal, you may have to foot a huge tax bill if you leave your employer.

For example, many 457 distribution plans require you to take the lump sum upon leaving. That’s a huge loss to taxes. Who wants to pay taxes on an additional $250,000-500,000 when you retire or leave your employer?  Particularly if it bumps you into the next tax bracket.

That’s what happens if you are forced to take the lump sum. So, if the lump sum is the only option, consider using a taxable account instead. However, if your plan allows you to take your distribution over a number of years, this is preferable in order to decrease the tax burden you might experience.

In order to know the specific options your 457 offers, request the plan documents and read them thoroughly.  They are required to provide them should you ask. Make sure you understand exactly what is being offered.

Step #3: Check the Investment Options

Some 457 plans only have high-expense ratio funds, and nothing else.  If this is the situation, don’t feel forced to take advantage of the tax savings just to turn around and invest in bad funds.

For example, let’s say that your 457 plan only offers actively managed mutual funds with an expense ratio of 1% (you can think of this as what it costs to “manage” the fund). Let’s compare this to a passively managed index fund which has an expense ratio typically 0.1% or less.

That’s a 0.9% difference. Let’s say that you plan to invest $23,000 per year for 30 years. If you were to get 8% with an index fund expense ratio of 0.1%, you get 7.9% returns annually. Your annual investment of $23,000 would turn into $2.5 million.

If, instead, you invested in actively managed mutual funds, this would reduce your returns by 0.9% (the difference between the active and passive funds). Instead of $2.5 million, you’d now have only $2.125 million. This is why passively managed index funds have been shown to beat actively managed funds more than 90% of the time after just 10 years:

 

 Source: SPIVA Scorecard 2022.

For this reason, if your 457 plan only offers expensive actively managed funds, just take your $23,000 home, pay the taxes, and invest in a taxable brokerage account instead. However, if your plan has low-cost index fund options, and the first two steps haven’t tripped you up, it’s definitely worth considering the use of your NG-457 plan.

Take Home: Should I Invest in my 457 plan?

If you have a governmental 457

The answer is easy.  If you have the income, then you should participate.  You can view this as an extra 401K/403B.

After you fill up your 401K/403B, the governmental 457 should be the next retirement space you fill up.  If you have room after that, then a stealth (HSA) IRA and backdoor Roth IRA are your next bets.  Then a taxable account.  Governmental 457’s make life easy.

If you have a non-governmental 457

All of the following assumes that your 457 has good options in which to invest (i.e. low expense-ratio passively managed index funds).  

The answer becomes more complicated.  The one thing that I can tell you that no one would disagree with is that you should be intimately familiar with your employer’s 457 plan.  Ask for it.  They are required to give it to you by law.

Depending on your goals, you may want to consider contributing to your other investment accounts available to you first (e.g. 401K/403B, stealth (HSA) IRA, cash balance plan, backdoor Roth, etc) before you consider a non-governmental 457. 

That said, if you are happy with your employer’s financial situation, the NG-457 offers good investment options, AND the distribution options are reasonable… then this may be a good way to fill the gap before age 59.5 when you can access your 401K/403B.