Retiree Portfolio The New and Improved 457 Plan

A 457 plan allows employees of certain organizations to make pretax contributions to a tax-deferred retirement account. Recent laws enacted by the Economic Growth and Tax Relief Reconciliation Act significantly increase the amount 457 plan participants can contribute. Therefore, 457 plan participants should examine these differences to enhance their retirement savings program.

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By David Braze (TMF Pixy)
October 8, 2001

The 457 plan is a deferred compensation plan established for the benefit of state and local government employees and the employees of tax-exempt organizations. Participants elect to contribute pretax money to their plans through payroll deductions. Until withdrawn, these contributions and all earnings remain untaxed.

Recent laws enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) have significantly enhanced 457 plans as retirement savings vehicles. However, those new rules won't be in effect until 2002. So let's first cover the rules as they exist for this year, and then we'll review the new provisions.

This year, 457 plan participants may defer up to $8,500 or one-third of their net taxable compensation (i.e., remaining wages after the contribution), whichever amount is smaller. (Note: Through mathematical wizardry, the limit of one-third of net taxable compensation usually -- but not always -- amounts to 25% of gross compensation.) Participants who are within three years of their plan's "normal retirement age" (i.e., the earliest age at which the plan permits a participant to retire) may exceed this limit under a "catch-up" provision. Under this provision, these folks may contribute as much as $15,000 per year to make up for any earlier years in which they did not participate fully in their 457 plans.

This year, the maximum 457 plan contribution limit is reduced dollar-for-dollar for those governmental plan participants who also make elective deferrals to any other plan offered by their employers (e.g., a 403(b) plan). To illustrate, a state or local government employee who contributes $5,000 to a 403(b) plan may only contribute a maximum of $3,500 ($8,500 minus $5,000) to a 457 plan this year. If that employee makes a contribution of $8,500 to the 403(b) plan, then no contribution may be made to the 457 plan.

The 457 plan assets of tax-exempt employers are subject to the claims of the employer's creditors, but those of plans sponsored by governmental entities are not. Plan distributions may occur at retirement; on separation from employment; as the result of an unforeseeable emergency; and at death. This year, employees who leave their jobs may transfer their 457 plan assets into a new employer's 457 plan that accepts such transfers; however, the assets may not be transferred to an IRA. If the money is distributed instead, on withdrawal it is subject to immediate taxation at ordinary income tax rates. But, because a 457 arrangement is a nonqualified retirement plan, withdrawals will not be penalized regardless of the age of the participant when they occur.

Thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001, 457 plans will become more like their 401(k) and 403(b) plan cousins as of Jan. 1, 2002. That means they have the potential of providing participants even more money in retirement. Major EGTRRA provisions that affect 457 plans include:

1) The annual elective deferral limit will be increased to match the limits available in 401(k) and 403(b) plans.
On Jan. 1, 2002, the maximum allowable dollar contribution will jump from today's $8,500 to $11,000. Just as with 401(k) and 403(b) plans, the maximum contribution limit to 457 plans will then increase in $1,000 annual increments starting in 2003 until it reaches $15,000 in 2006. When the new limit is reached, the maximum contribution will be indexed in $500 increments for inflation.

2) The maximum deferral percentage will increase to 100% of taxable compensation after subtracting 457 plan deferrals.
Under today's rules, someone who made $34,000 annually is allowed a maximum contribution of $8,500 or 25% of that yearly wage. But starting next year, the same salary is eligible to contribute the full $11,000. In fact, someone making $22,000 per year may do the same in 2002 because 100% of the taxable compensation after the deferral is $11,000 ($22,000 - $11,000 = $11,000).

3) For those within three years of normal retirement age, the catch-up contribution limit of $15,000 will increase to double the normal yearly contribution limit.
If a 457 plan participant has sufficient unused deferrals from prior years, next year he or she may make a total contribution of twice the normal limit of $11,000, for a total of $22,000. Those who use this proviso in 2006 and later may put aside $30,000 instead of that year's former contribution limit of $15,000.

4) Participants age 50 or older who don't use the "within three years of normal retirement catch-up limit" will be able to take advantage of an additional contribution identical to the catch-up limits for 401(k) and 403(b) plan participants.
Next year 457 participants age 50 or older may add an additional $1,000 to their normal contribution, for a total contribution of $12,000. And they may use this "over-50 catch-up" provision as long as they are participating in the plan and are not using the "within three years of normal retirement catch-up limit" provision. By 2006, this extra allowable contribution will grow to $5,000 per year.

5) Any requirement to coordinate contributions to a 457 plan and contributions to a 401(k) or 403(b) plan will be eliminated.
Beginning in 2002, someone who participates in both a 457 plan and a 401(k)/403(b) plan may make a maximum contribution to both plans without having to reduce the 457 plan contribution. Thus, assuming they have the compensation to do so and the plans have no other limiting restrictions, 457 plan participants may contribute $11,000 to a 401(k) or 403(b) plan and another $11,000 to a 457 plan for a combined contribution of $22,000.

6) Participants in a governmental 457 can transfer plan assets from and to traditional IRAs, 401(k)s, 403(b)s, and other 457s.
This means that when leaving his or her current place of employment, a governmental 457 participant may transfer plan assets to an IRA or to a new employer's plan that accepts such transfers. This may or may not benefit the participant because, upon transfer, the assets will become subject to the rules of the new retirement vehicle. If that new vehicle is not another 457 plan -- i.e., it's an IRA, 401(k), or 403(b) -- then any withdrawals taken prior to age 59 1/2 will be subject to the early withdrawal penalty. For those who wish to retire prior to that age, that restriction could cause a problem.

There, in a nutshell, is an overview of 457 plan features. Given the recent changes to 457 plan law enacted by the EGTRRA, in some ways these plans have now become a better retirement tool than their 401(k) and 403(b) cousins.

That's all for this week, and soon to be all permanently for this writer. Comments? As usual, post away on the Retirement Investing or the Retired Fools boards.

Best to all... Pixy

The Motley Fool may be all about investors writing for investors, but Dave Braze is all about retirement. He will reach that blissful state finally (and none too soon in the minds of his editors) in another 53 days. Unfortunately, his better half has yet to decide whether that is a blessing or a curse when it comes to her contented life.