This article was updated on Nov. 8, 2017. It was originally published on Oct. 9, 2015.
In the world of workplace-based retirement plans, the 401(k) plan reigns supreme, but many workers are instead offered a 457 b plan to help them sock money away for their retirement -- and that's just fine. Sharing many features with the 401(k), a 457 b plan has the power to help you build serious wealth and enjoy a happy retirement.
Nuts and bolts
A 457 b plan is mainly for employees of state and local governments -- but not the federal government. (Federal workers can save through the Thrift Savings Plan.) It is also offered by some tax-exempt organizations.
Your contributions to a 457 b plan are deducted from your paycheck. For 2017, the maximum 457 b contribution is $18,000, and for 2018, it goes up to $18,500. On top of that, in both years, those aged 50 and up can make a "catch-up" contribution of up to $6,000, for a grand total of $24,000.
There's also a special catch-up contribution allowed for 457 b plan participants who are within three years of their "normal retirement age" and who have not contributed enough to their plan. The normal retirement age is determined by the employer and the plan -- for example, some local fire departments might have a normal retirement age of 40, while other positions have a normal retirement age of 55 or even 65. If, in the three years leading up to your normal retirement age, you are not making the regular catch-up contribution of up to $6,000, you can take advantage of the special one, which has a limit of either twice the regular annual limit or the basic annual limit plus the amount of the basic limit not used in prior years -- whichever is lower. For example, in 2017, if you have contributed $20,000 less to your plan than you could have, then your special catch-up limit is $20,000. If you have under-contributed $40,000, then it's $36,000 (twice the ordinary annual limit for 2017).
Like 401(k) plans, many 457 b plans are now offered in both the traditional and Roth variety. With a traditional 457 b, your contribution is deducted from your taxable income, reducing your taxes for the year in which you contributed. So if you earn $75,000 and contribute $10,000 to a traditional 457 b, then your taxable income drops to $65,000 and you defer paying taxes on the $10,000. If you're in the 25% tax bracket, this would save you $2,500 in income tax. However, in retirement your withdrawals from the account will be taxed at your ordinary income tax rate.
The Roth 457 works differently. Your contribution doesn't have any effect on your taxes in the contribution year, because it's made with post-tax money. That might seem like a disadvantage, but get this: If you follow the rules, then you can withdraw your money tax-free in retirement. That can be very powerful.
Choices and matches
While money in regular brokerage accounts and most IRAs can be invested in just about any stock and a huge variety of mutual funds, the investment choices available in a 457 b account are more limited, as they are in 401(k) plans. Typically, there will be a range of choices, such as a few managed stock and bond funds and some index funds.
Meanwhile, whereas the typical 401(k) plan will offer some matching funds from the employer, 457 b plans rarely offer an employer match. That's because most 457 b plan participants are government workers who are eligible for pensions. Thus the 457 b plan is more of a supplemental retirement plan than a critical primary one.
More powerful than a locomotive
Even if it's a supplemental retirement plan, a 457 b plan can be surprisingly powerful. For example, imagine that you contribute $7,500 per year for 25 years and your money grows at an annual average rate of 8%. In that case, you'll end up with nearly $600,000. If you can up your annual contribution to $10,000 and you manage to earn an average of 10% per year by investing primarily in stocks, then you'll end up with nearly $1.1 million. If you're still early in your career and can't afford those kinds of contributions, fear not -- because time is on your side: If you contribute $5,500 per year and earn a reasonable 8% on your investments, in 30 years' time you'll have a million bucks.
You can amass even more than that if you contribute more each year to your account -- especially in your early years, as early investments have the longest time to grow. Remember: The contribution limit is at least $18,000 in 2017, and it's raised over time to keep up with the cost of living.
A 457 b plan is also powerful because it can be used and funded in addition to a 401(k) plan or other retirement plan, if one is available to you.
Don't ignore the 457 b plan if your job offers you one. It can provide a big chunk of the income you'll need in retirement, and might even help you live it up in your golden years.
The Motley Fool has a disclosure policy.