401(k) vs. 457(b) - What are some of the major differences?

The 401(k) plan and the 457(b) plan are two forms of tax-advantaged employee retirement savings programs approved by the Internal Revenue Service. Participants in such programs can contribute pre-tax money, which accumulates tax-free until it is withdrawn.

These retirement savings plans were created to be one of the three components of the well-known retirement benefits - workplace pensions, Social Security, and private retirement savings. Together with Social Security, personal retirement funds are increasingly becoming the primary retirement plan for most individuals as job pensions become outdated.

401(k) and 457 plans, for example, are very similar in function, with the key distinction being who is authorized to enroll in each.

401(k) Plans

401(k) plans are the most popular form of defined-contribution retirement plan, and they are provided by private, for-profit companies and some nonprofit organizations. 401(k) plans, for example, are classified as qualified retirement plans and are thus bound to the 1974 Employee Retirement Income Security Act (ERISA).

Employers who sponsor 401(k) plans can contribute matching or non-elective contributions in favor of their eligible employees. A 401(k) plan allows you to save money while deferring taxes. On the other hand, it also provides a menu of prescreened investment choices from which participants can decide how to invest their own money.

For 2021 the annual maximum contribution limit is $19,500 ($20,500 for 2022). Both plans provide a catch-up option for workers above the age of 50, allowing up to $6,500 in extra payments.

Withdrawing funds from a 401(k) before the age of 59½ are subject to a 10% early withdrawal penalty. However, under the "financial hardships" category as defined by each 401(k) plan, participants can withdraw money from a 401(k) without penalty.

In 2006, another 401(k) was introduced, combining characteristics from the standard 401(k) and the Roth IRA. It is called the Roth 401(k). Similar to the traditional 401(k), a consumer may use a Roth account to get the benefits of an employer matched on the contributions. In addition, the Roth characteristics of the Roth 401(k) allow consumers to withdraw money without paying taxes.

457 Plans

457(b) plans are IRS-approved, tax-advantaged employee retirement plans sponsored by state and local governments and some charitable organizations. They're one of the less popular types of defined contribution retirement plans.

Workers contribute via paycheck deductions to 457 defined-contribution plans. Participants of the plan reserved a percentage of their income for contributing to their retirement account. Unless the participant sets up a Roth account, these contributions go tax-free into the retirement account, and any future growth is tax-free.

For 2021 the yearly maximum contribution limitation for 457 plans is $19,500 ($20,500 for 2022). Both plans provide a catch-up option for employees over the age of 50, allowing up to $6,500 in additional payments. Employees who contribute to each plan are eligible for a "saver's tax credit." 457 plans can be used to borrow money. ERISA does not apply to 457 plans, which are a sort of tax-advantaged nonqualified retirement plan.

Because ERISA restrictions do not apply to 457 accounts, the IRS does not charge an early withdrawal fine to 457 participants who withdraw funds before reaching the age of 59½, albeit the funds are still subject to regular income taxes.

In addition, unlike 401(k) plans, 457 plans have a double limitation catch-up provision. This provision is intended to help members approaching retirement to make up for years when they were qualified to participate in the plan but did not. An employee could contribute up to $39,000 to a retirement plan in 2021 ($41,000 in 2022).

Factors making both plans differ from each other

Eligibility Factors

• Specific nonprofit organizations are permitted to offer 457(b) plans, but they are primarily available to federal employees. Authorities at the local and state levels, public school instructors, county and city employees, police enforcement, and first responders are all examples of federal employees.
• Some major government firms provide both 401(k) and 457(b) plans, allowing employees to contribute to both. This allows them to save twice as much money.
• Nonprofit and for-profit businesses and some federal agencies may provide 401(k) plans if they started before May 6, 1986.
• 457(b) plans are not covered by the Employee Retirement Income Security Act of 1974 (ERISA), but 401(k) plans are.

Plan Limits

• The income deferral limit refers to the amount of pre-tax money you can put into a 401(k) plan. The cap for 2022 is $20,500, up from $19,500 in 2021. If you're 50 or older and the plan allows it, you may also pay catch-up payments of up to $6,500.
• The lower of 100 percent of the employee's includable pay or the elective deferral limit is the limit for all savings to 457(b) plans. For 2022 and 2021, the optional deferral maximum for 457(b) plans is likewise $20,500 and $19,500, respectively.
• During the three years before your usual retirement age, your plan may allow special 457(b) catch-up contributions for extra savings. You could save less than twice the limit ($41,000 in 2022, $39,000 in 2021) or the basic limitation per year, plus any unused portion of the basic limit from previous years. You may use the bigger authorized deferral if your plan allows both the special 457(b) catch-up and the age-50 catch-up. But you can't use both at the same time.
• Since a 457(b) plan is a nonqualified plan, the IRS enables you to contribute to both a 401(k) and a 457(b) plan at the same time.

Affordability

• Administrative and maintenance fees for 457(b) plans may be greater than for other forms of employer retirement plans. You might get a more limited variety of investment possibilities within the plan to pick from, which could be a problem for your diversification plan.
• Fees and investment options tied to individual plans are some of the disadvantages of 401(k)s. Specific plans may impose more administration fees and reduce returns. Alternatively, your plan might not include the investments you want to add to your portfolio.

Hardship distribution permission

• Hardship distributions are allowed in a 457(b) plan if required due to an unforeseen emergency, such as sickness, accidents, natural catastrophe, or other extreme and unpredictable circumstances stemming from circumstances beyond the participant's (or beneficiary's) influence. It is also permissible if the member has exhausted all other financial options and the amount distributed is required to meet an emergency requirement (and tax liability arising from distribution)
• It is permissible in 401(k) plans if the payout is required to fulfill an immediate and significant financial necessity. Note that the requirement does not have to stem from an unexpected event, such as medical bills, acquiring a primary house, education and associated room and board fees for an employee, employee's spouse or children, or expenses to avoid eviction or foreclosure. In addition, the participant must exhaust all other sources of funding, and the amount distributed is required to meet the participant's financial needs (and tax liability arising from distribution).

Early-Withdrawal Penalties

• You could double the tax-deferred savings and lower your taxable income by contributing to both types of programs. Since there are zero early-withdrawal penalties on a federal 457(b) plan, having both kinds of accounts may be beneficial if you need to withdraw funds.
• You don't have to pay taxes on any tax-deferred retirement savings until the money is withdrawn from the account, and it will be subject to income taxes once it is withdrawn from a typical 401(k) plan. If you take a withdrawal before the age of 59½, you may be liable to a 10% early-withdrawal penalty in addition to any income tax.
• Withdrawals from a 457(b) plan are subject to income tax, but they aren't liable to the early-withdrawal charge, so you won't be penalized an extra 10% penalty.
• If you're not yet 59½ and realize you've exceeded your limit, you can take the excess from your 401(k) plan until the tax filing date, which is usually April 15 in most years. The sum is still included in your gross revenue for the year, but you won't have to pay the penalty.

Rollover Option

• When a person quits one business for another, he or she has the option of rolling over his or her 401(k) into another 401(k) plan or an IRA. If the 401(k) amount is greater than $5000, they have the option of leaving it with the company indefinitely rather than shifting the assets to another retirement plan.
• Rollovers are only available to employees enrolled in a government 457 plan. You can move your savings to a 457 plan or a standard IRA at your new company when you quit your current work. You have the option of rolling the funds over immediately to an IRA or withdrawing the monies from your 457 accounts and depositing them into an IRA account within one month.
• There are more limits with a non-federal or private tax-exempt organization, and you can't roll over the funds to a typical IRA. Instead, 457 members have the option of leaving their assets with their employer, taking a payout, or transferring their funds to another non-federal plan.

Why do government employees have a 457(b) plan instead of a 401(k)?

When discussing defined contribution plans, the 457(b) shares more similarities than distinctions with its corporate version, the 401(k). However, those key distinctions are essential, and individuals who have both types of accounts should pay close attention.

By establishing a 457(b) plan, government firms can offer equal retirement savings opportunities as private, for-profit companies. The opportunity to offer comparable retirement benefits to private-sector companies might help government employers compete for top personnel.

457(b) programs may also allow employees to save money three years earlier than their "normal retirement age," as defined by the plan. Although the regular retirement age varies, special contributions might start three years before that.

Employees may contribute double the standard, elective deferral maximum, or the sum of the current year's ceiling with unused portions from preceding years, whichever is smaller, during each of the three years.

Employees in the state and local governments are rarely matched. The yearly contribution limit for 401(k) and 403(b) plans applies solely to employee deferrals, not any money "matched" by the employer. A government employer's contribution to a 457(b) plan, on the other hand, counts toward the year's total permitted limit.