Understanding the Key Differences and Which Plan Is Right for You
When it comes to retirement planning, knowing your options is essential for building a secure financial future. For employees of government and some nonprofit organizations, the most common retirement plan is the 457(b).
For private-sector employees, the most common plan is the 401(k). These plans both offer significant tax advantages and allow individuals to save for retirement, but there are key differences between them.
In this post, we’ll compare the two, explain the advantages of each, and guide you on which one might be best for your retirement goals.
The Challenge of Retirement Plan Confusion
For many people, retirement planning is a confusing maze of options, with different rules and features depending on the plan. When you hear terms like “457(b)” and “401(k)” tossed around, it can be tough to know which plan you have.
The underlying issue is that both of these plans sound similar on the surface—both allow for pre-tax contributions, both grow your savings tax-deferred, and both can play a role in securing your future. Some plans may even offer a Roth function.
But they are far from identical, and contributing to the correct plan is critical. For instance, let’s say you’ve been contributing to a 457(b) at your current job but are moving to a private sector job that offers a 401(k). Should you just rollover the 457(b) into the 401(k)?
You’ll no longer have access to contribute to the 457(b), but the 401(k) might have features that make it advantageous. These are the types of questions people often ask, and it’s easy to see why confusion about these plans is common.
Should I Roll My 457(b) into my new 401(k)?
As a financial advisor specializing in 457(b) plans, I’ve seen firsthand how challenging it can be understanding the differences between a 457(b) and a 401(k), especially when transitioning from a government job to the private sector.
One client of mine, a long-time government employee, was nearing retirement when they began receiving job offers from private companies, each with a 401(k) as part of the benefits package. While they were happy with their current 457(b) plan, the potential transition left them wondering how the change might affect their long-term savings strategy.
This client had been contributing to their 457(b) for over a decade, and the plan had certain features that made it especially attractive for their retirement goals. However, after reviewing IRS rules and weighing their options, they decided against rolling over their 457(b) to a new 401(k).
The reason? A major advantage of the 457(b) is that it’s employment-restrictive. Once an individual separates from service, they have immediate access to the funds, unlike a 401(k), which funds can not be withdrawn until 59 ½. In a 401(k), there is the age 55+ provision and 72(t) distributions, but we are speaking generally.
Although taking a withdrawal from their 457(b) could impact the future performance of their retirement account, it provided much-needed flexibility. The ability to access funds without penalty upon separating from service meant that, should they need to make any adjustments to their retirement strategy in the near term, they could do so without incurring additional costs.
This flexibility, however, came with tax implications, which is something to consider when deciding how to handle withdrawals from a 457(b).
In the end, the decision not to roll over the 457(b) was strategic, as the client chose to leverage the unique advantages of the 457(b) plan—specifically the ability to access funds without penalty after leaving service—while also understanding the potential tax consequences.
What is a 457(b) Plan?
A 457(b) is a type of deferred compensation plan typically available to government employees and some employees of nonprofit organizations. It allows employees to contribute a portion of their salary before taxes or after-tax, depending on your plan. If you’re looking for more detail on the 457(b) plan, view our deferred compensation guide.
What is a 401(k) Plan?
The 401(k) plan is primarily available to employees working for private-sector companies, though some public entities may also offer them. Similar to the 457(b), it allows for pre-tax or Roth contributions, depending on your plan. The big difference with a 401(k) is that there are more widespread employer contribution matching programs, meaning your employer may match a percentage of the contributions you make to the plan, which effectively increases your retirement savings.
The Key Differences Between the 457(b) and the 401(k)
- Early Withdrawal Penalty: One of the key advantages of the 457(b) over the 401(k) is that it does not have the 10% early withdrawal penalty if you separate from service before the age of 59½. This is a significant advantage for government employees who might retire earlier or face an unexpected job change.
- Employer Matching Contributions: While both the 457(b) and 401(k) plans may have employer contributions, 401(k) plans generally offer more robust matching contributions compared to the 457(b). If your employer offers a generous match, the 401(k) may be more beneficial for you in the long term.
- The reason 457(b) plans don’t offer matching programs is because most of the time the entity offers pensions. This requires the employer to contribute a portion of your paycheck towards your pension fund.
Any Other Considerations?
Step 1: Assess Your Eligibility
The first step is to determine which plans are available to you based on your employer. If you work for a government agency or a nonprofit organization, you may have access to a 457(b). If you work for a private-sector employer, a 401(k) plan is most likely the option available.
Step 2: Consider Withdrawal Flexibility
If you expect to retire early or might need to access your retirement funds before the age of 59½, the 457(b) is generally the better choice, as it does not carry the same early withdrawal penalties as the 401(k). This flexibility can be crucial if your retirement plans don’t fit the traditional mold.
Step 3: Maximize Employer Matching Contributions
If you are participating in a 401(k), ensure you are taking full advantage of any employer matching contributions. This is essentially “free money” that can significantly boost your retirement savings over time.
Step 4: Reassess Periodically
Your situation may change as your career progresses, so it’s important to periodically reassess whether you should continue contributing to a 457(b) or 401(k), or whether a combination of both plans makes sense for you.
Choosing the Right Plan for You
Choosing between a 457(b) and a 401(k) plan depends on your employment status and employer benefits. Understanding the differences between these two retirement plans is essential for making an informed decision.
By carefully considering your eligibility, contribution limits, early withdrawal needs, and the availability of employer matching contributions, you can make the best choice for your retirement planning.