You’re never too young to invest in a sound retirement plan. Most physicians are around 30 by the time they finish training and start practicing medicine. Getting that later start makes it crucial that you start saving for retirement early on in your career.
But with so many investment options and retirement plans to choose from, it can be difficult to determine which one is best.
Most physicians working as employees of large hospital groups will have the opportunity to invest in a 403b or 401k. Many physicians working for governments and tax-exempt organizations will have the opportunity to invest in a 457(b) plan instead.
Not sure how the 457(b) works?
Here’s what physicians should know about 457(b) deferred compensation plans.
What is the 457(b)?
The 457(b) is:
- A personal retirement savings plan provided to employees of state and local governments as well as tax-exempt organizations, such as charities and nonprofits.
- A tax-advantaged plan that allows you to contribute pre-tax dollars. Contributing pre-tax dollars reduces your taxable income each year, so you’ll pay less in federal income tax to the IRS. However, you will pay taxes when you withdraw the funds in retirement.
- A non-qualified plan, so you can invest in it at the same time you are investing in other plans, such as the 403(b). For physicians looking to maximize their retirement savings with tax-deferred income, it is best to max out the contributions to a 403(b) first and then contribute additional pre-tax money into a 457(b).
How is the 457(b) Different From the 403(b)?
Both 457(b) and 403(b) plans are offered to state and local government employees and some employees of certain nonprofit and charitable organizations. High-level executives at nonprofit hospitals and charities are also eligible participants in these deferred compensation plans.
Depending on your position and employer, you may be eligible to invest in both at the same time.
If you meet the eligibility requirements to invest in both, it’s important to understand how the 457(b) and the 403(b) differ and how they are the same.
There Are Many Similarities Between the 457(b) and the 403(b)
The 457(b) and 403(b) have several things in common.
Both are funded by a portion of an employee’s salary and, in some cases, an employer match. As of 2020, both have annual employee contribution limits of $19,500 per year, and both are tax-deferred plans designed to reduce your taxable income.
In addition to the annual contribution limits, both plans allow you to make catch-up contributions if you are over the age of 50. As of 2020, the 457(b) allows you to contribute an additional $6,500 per year. The 403(b) allows for the same extra $6,500 contribution, but it allows for an added contribution as well.
With the 403(b), employees with at least 15 years tenure at their current employer have the option to contribute an additional $3,000 per year, up to a maximum of $15,000 in the employee’s lifetime with that employer.
The Key Differences Between the 457(b) and 403(b)
Despite the elements that the 457(b) and 403(b) have in common, there are many distinctions between these two types of retirement plans.
Many retirement plans, including many 403(b) plans, are protected under ERISA (the Employee Retirement Income Security Act) and categorized as qualified retirement plans. With an ERISA-protected plan, your retirement savings cannot be seized in bankruptcy, through civil lawsuits, or through creditors to whom you owe money.
457(b) plans are not governed by ERISA and do not offer these protections. However, because they do not have to comply with ERISA guidelines, how they handle early withdrawals and hardship distributions is also different.
403(b) plans, like 401k plans, require that you be age 59 ½ or older to make withdrawals. If you take funds earlier than age 59 ½, you’ll pay a 10% penalty for early withdrawals in addition to the income taxes owed.
457(b) plans allow you to make withdrawals at any age, provided that you leave the employer with whom you have the plan. There is no penalty for early withdrawals. This makes it one of the best options for physicians who want to retire earlier than the normal retirement age of 66.
Hardship distributions are also handled differently. 457(b) plans make it difficult to qualify for a hardship withdrawal. To make a hardship withdrawal on a 457(b), you must have an unforeseeable emergency.
403(b) plans tend to be less stringent on the qualifications needed to take a hardship withdrawal from your deferral account.
Depending on your employer and your specific plan, your employer may match your contributions. How much your employer can contribute to your plan varies significantly between the 457(b) and the 403(b).
With a 457(b), your maximum annual contribution is $19,500. That amount includes plan contributions made by the employee and the employer.
With a 403(b), the employee has a maximum annual contribution of $19,500, but the employer can contribute on top of that amount. For 2020, employers can contribute up to $37,500 for a total maximum contribution of $57,000 per year. Employer contributions such as this are not typical, but they are allowed.
The Benefits of the 457(b)
There are many benefits to saving for retirement with a deferral account, such as the 457(b). Here’s why it’s a good idea to make the 457(b) a part of your overall retirement savings plan.
The key benefit of the 457(b) is that it is a tax-deferred plan. Any contributions you make to the plan are made with pre-tax dollars, thus reducing your taxable income so that you can pay less in federal income tax. Earnings made on your contributions, through investments such as mutual funds and annuities, also grow tax-deferred.
You will only pay taxes on these funds when you start to make withdrawals in retirement.
No Penalties For Early Withdrawals
Unlike 401k and 403(b) plans, you do not have to pay a 10% penalty for early withdrawal. As long as you retire or switch jobs, you can withdraw your funds at any time. This makes it a great option for physicians who may want to retire prior to the age of 59 ½.
You Can Choose Different Investments
Employees with a 457(b) plan can choose to invest in a variety of different funds. Depending on the specific plan offered by their employer, they can invest their deferred compensation in mutual funds or annuities. Earnings on those funds also grow tax-deferred and are only taxed upon withdrawal in retirement.
The option to choose where you invest your annual contributions allows you to have more control over where your money goes. Younger physicians may want to invest in funds that have more risk (but the possibility for greater reward). Older physicians might prefer to invest in lower-risk funds in order to maximize and protect their savings as they near retirement.
If you’re over the age of 50, the 457(b) allows you to make catch-up contributions to save even more money for retirement. In addition to the $19,500 maximum annual contribution, you can contribute an additional $3,000 per year starting at age 50.
In the three years leading up to retirement, you can make even larger contributions through an additional catch-up provision. If you have not contributed the maximum amount in previous years, you can contribute up to $39,000 per year for the last three years to “catch up” on savings you didn’t defer earlier in your career.
The Drawbacks of the 457(b)
There are a few drawbacks to the 457(b) as well. Here are the key things to keep in mind in order to make sure that you have a sound retirement savings plan in place.
Deferred Compensation Means It’s Not Your Money (Yet)
A 457(b) is a salary deferral plan as opposed to a traditional retirement savings plan. And that’s because technically, the money isn’t yours yet. Your deferred income still belongs to your employer.
Difficult to Take Hardship Distributions
401k and 403(b) plans make it relatively easy to borrow money for financial hardship. The 457(b) plan sets the bar much higher in order to qualify for a hardship distribution.
For example, with a 403(b) plan, you may be able to take an early distribution to pay for college or purchase a home. Most 457(b) plans require that you incur an unforeseeable financial emergency, such as the need to pay for unexpected medical costs.
No ERISA Protection
Because 457(b) plans are not governed by ERISA, you lose the protections that ERISA laws provide. Depending on your particular 457(b) plan, your deferral account may not be protected from creditors.
Employer Matching is Uncommon
Since the 457(b) is primarily offered to government and non-profit employees, it is uncommon for employers to offer matching contributions. And even if your employer offers a 100% match, you cannot exceed the maximum amount of $19,500.
With a 100% matching program, the employee can contribute a maximum dollar amount of $9,750, and the employer can contribute a maximum of $9,750, but not a dollar more.
457(b) plans often incur administrative and management fees, so you can expect a percentage of your contributions to go toward paying those fees. Before you start making contributions to a 457(b), ask your plan administrator to provide you with documentation of any and all associated fees.
Required Minimum Distributions
Like the 401k and 403(b), the Internal Revenue Service has a Required Minimum Distribution amount that you must take from your 457(b) when you reach age 72 (or 70 ½ if you turned 70 ½ prior to January 1, 2020).
Because of the RMD rule, you cannot let your money sit in your 457(b) plan forever. At some point, you will have to start making withdrawals (and paying taxes on those withdrawals).
The Backdoor Roth IRA
If you leave your employer, you may be able to rollover your 457(b) funds into an IRA. However, if you’re looking for a way to enjoy some retirement income tax-free, you’ll want to have a Roth IRA and/or a non-qualified executive benefit plan. For physicians and high-income earners looking to save more and enjoy more tax advantages, you may want to use the backdoor Roth IRA.
For more information on the backdoor Roth IRA, check out our Physician’s Guide to Backdoor Roth IRAs.
Different Types of 457(b) Plans
There are two different categories of 457(b) plans: one for government employees and one for qualifying employees that are not directly employed by any form of government. They have many similarities, but there are some differences between the two.
Governmental 457(b) plans sometimes allow you to roll over funds into IRAs and other eligible retirement plans. They also allow contributions to go into a trust and permit loan withdrawal.
Government plans also let you make catch-up contributions if you’re over the age of 50. With a government plan, you are only taxed on your contributions once you start receiving plan distributions.
Non-governmental 457(b) plans do not allow you to roll over funds, do not make contributions to trust, and do not allow for catch-up contributions.
The other main distinction is that you will be taxed on the funds when they are made available to you, even if the date of availability is prior to the date you start taking distributions.
Interested in early retirement? Get an Early Retirement Evaluation.
Consult a Financial Advisor
Before you enroll in any retirement plan, consult with a financial advisor.
Retirement plans work in different ways and offer different retirement benefits and deferral limits that vary based on your age. A financial advisor can help you maximize your benefits early in your career so that you can live the retirement you want.
Whether you choose a 457(b), a 403(b), or some other retirement savings plan, begin the enrollment process as soon as possible. The sooner you get started, the bigger your retirement account can be.
For more information on retirement planning, financial planning, and tax planning, contact Physicians Thrive now.
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