Contribute As Much As You Can to a 457 Plan

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A 457 Deferred Compensation Plan, called “457 plan” for short, is a type of retirement plan that is available to governmental employers and some non-governmental non-profit employers in the United States. Many 457 plans offer both a traditional pre-tax deferral side as well as a post-tax Roth deferral side.

Along with a 457 plan, many employers also offer a 403(b) Tax-Sheltered Annuity Plan, called “403(b) plan” for short. A 403(b) plan is like a 401(k) plan except that there are a few differences. One advantage is that an employee who has been serving for 15 years or more may have a higher contribution limit for the year. One disadvantage is that 403(b) plans are limited in their investment options to only annuity contracts or mutual funds. Also, 403(b) plans can only be offered by a public or non-profit organization.

Non-profits can offer any combination of 401(k), 403(b), or 457 plan. While a 457 plan has its own employee and employer contribution limits, a 401(k) and 403(b) plan share the same contribution limits, so most employers select only one of these two plan options to offer. For example, locally in Charlottesville, the University of Virginia offers many highly compensated employees the opportunity to participate in both a 403(b) plan and a 457 plan.

If you have the ability to participate in two plans, then you have the opportunity for large savings.

In 2019, the 401(k)/403(b) employee elective deferral limit is $19,000 ($25,000 for those age 50 or older) and the 457 plan employee deferred compensation limit is also $19,000 ($25,000 for those age 50 or older). You can see the current contribution limits here.

If you participate in both types of plan, you can then defer $38,000 ($19K + $19K) into retirement plans, $50,000 ($25K + $25K) if you are age 50 or older. These deferrals are on top of any IRA contributions you’d like to make. In 2019, the IRA contribution limit is $6,000 ($7,000 for those age 50 or older).

If you imagine a husband and a wife who are over age 50 and each have access to a 403(b) and 457 plan, that means that they would be able to save a joint amount of $114,000 ($50K + $50K + $7K + $7K) into retirement accounts each year.

The tax benefits of this technique are tremendous, especially if all of those contributions are put in Roth options.

And this technique can be even if the couple cannot afford to to make these deferrals out of their salary.

Imaging a couple, John and Mary, who are both working at the University of Virginia. Mary is a professor earning $100,000 per year. John is an assistant professor earning $80,000 per year. They are currently contributing only about $10,000 per year to their retirement plan options. Their federal taxes are about $26,200 and their state taxes are about $9,900. After taxes and retirement contributions, their take home pay is about $133,900. They have a lifestyle of about $120,000.

It may look like John and Mary cannot contribute much more to their retirement plans without reducing their lifestyle. But John and Mary have about $570,000 in investments in a taxable brokerage account.

Any time a family has investments in a taxable brokerage account, outside of a retirement account, they are candidates for funding Roth accounts even when they can’t afford to reduce their lifestyle.

John and Mary’s brokerage account is generating interest, dividends, and capital gains each year. If the account grows by 10% one year it generates $57,000 in interest, dividends, and capital gains. Even if all of those gains are qualified and therefore subject to the lower capital gains tax, that is still a significant amount of tax. They could owe a tax of about 20.75% (15% federal and 5.75% Virginia state) or $11,827. The higher inflation is, the greater investments growing in a taxable account will be taxed.

Money growing in a taxable brokerage account is very inefficient. In Virginia, it is often taxed at this 20.75% rate, thereby reducing the annual gain on the account by as much as 2% per year. The headwinds of this capital gains tax over the next thirty years is tremendous.

If the $570,000 were in a Roth growing at a modest 7%, it would grow to $4.3 million over the next 30 years. With the $570,000 in a taxable brokerage account growing at 7% and paying 20.75% on the growth, it would only grow to $2.9 million. In this case, it is worth about $1.5 million to get the money from a taxable brokerage account into a Roth account.

For John and Mary, getting it there is relatively easy.

All John and Mary have to do is to start taking advantage of the maximum Roth contributions allowed under their employment with the University of Virginia. Together they can contribute $114,000 into Roth accounts!

Although this means deferring basically all of their salary, drastically reducing their take home pay, John and Mary can simply switch to withdrawing from their taxable brokerage account to satisfy their lifestyle.

After Roth deferrals, Roth contributions, and taxes, John and Mary receive $19,900 ($133.9K – $114K) in take home pay. To meet their lifestyle needs of $120,000, this means supplementing with a $100,100 withdrawal from their taxable account.

This has the effect of moving money out of their taxable brokerage account where it is taxed each year into their Roth accounts where it is never taxed again. After five years, they will have moved the entire $570,000 out of their taxable brokerage account and into Roth accounts.

Tax planning like this is worth a great deal of money over your lifetime. If your employer offers a 457 plan, consider taking advantage of the ability to shelter more money each year from taxes in a Roth account.

Photo by Jennifer Pallian on Unsplash

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

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