A Story of 403b v. 457

People who work in the public non-profit sectors may have a choice in the Defined Contribution Plan (403b or 457)from their employer.  We’re often asked which is better or what makes the most sense for me and my family.  Like most things in the financial world, “It depends!”

Defined Contribution plans come in many flavors.  But, for public employees, it basically boils down to 403(b) Plans, 457(b) Plans (both shortened herein). Federal employees have access to Thrift Savings Plans (TSP). I’m going to explain the features and benefits of each of the first two plans and save TSP for a separate article.

A 403b plan is typically offered to government employees, employees of privately owned nonprofit businesses and churches. This would include government employees at almost any level including public school employees. Like the well-known 401k, 403b plans are a type of “defined-contribution plan”. All of these plans allow employees to shelter money on a tax-deferred basis for retirement. You put untaxed money into the plan and it grows “tax-deferred” until withdrawal. These plans became law in 1958. Originally known as tax-sheltered annuities (TSA) or tax-deferred annuities (TDA) plans, they could only be invested in annuity contracts at that time. These plans are most commonly used by educational institutions.  I can remember my mother-in-law having those as late as the 70’s.

457b plans are offered to state and local government employees and are a form of deferred compensation.  In other words, you defer your current compensation to a future date.  In addition, you can invest the deferred compensation and grow it tax-deferred until you withdraw at a future date.

Both plans have two types of deferral:

• Non-Elective Contributions are contributions made by the employer in the employee’s name.
• Elective Deferrals are contributions determined by the employee and withheld from their paycheck.

PROS

• Both plans offer deferral of current taxes and tax-deferred growth
• 403b plans have a maximum employee contribution of $18,500 for 2018
• 403b plans can have additional matching funds added by the employer raising the aggregate total to $55,000/year in 2018
• 457 plans have a maximum total contribution of $18,500 for 2018
• Both plans have Catch-up provisions for people over 50.  Allowing an additional $6,000/year
• 457 plans are not ERISA governed plans and have no early withdrawal penalty
• 457 plan allows for a double catch-up ($12k/yr.) for people who have under contributed over the life of their plan
• Many 403b plans have loan provisions. The maximum under the law is $50,000 or ½ of your account (whichever is less)

CONS

• 403b plans have a 10% tax penalty for pre- 59 ½ distributions (in most cases)
• Both plans require a minimum distribution (RMD) each year after the year you attain 70 ½ years of age. The percentage of distribution goes up each year after that.
• You must take your RMD whether you want to or not
• Not taking RMD subjects you to a 50% tax penalty on the amount you did not withdraw. OUCH!!
• RMDs can subject you to the extra taxation of Social Security Benefits
• You may have limited investment choices (more later)
• Withdrawals are treated as ordinary income when much of the growth is actually capital gains

SUMMARY

All of this is informational and not an attempt to dissuade anyone from joining a plan.  These plans are probably the best any of us will see for saving toward retirement.  As I said earlier, the plan you pick will depend upon many things, including Marital Status, age, health, prior savings, future plans (ie: financial plan), spouses access to a plan, intended retirement age, part-time work in retirement and more.

Your employer may offer both plans.  But, inside each plan is a host of offerings from various annuities to brokerage plans.  Each of these plans has their own pros and cons.  Wading through this muck often requires professional advice.

“Plan Early and Plan Often!”™

The IRS just gave guidance that a “nondeductible” IRA may still be converted into a Roth IRA.  We have had our concerns that the new tax codes might have changed the IRS interpretation.

Until 1997, taxpayers over a certain level of income were no longer able to deduct their IRA contribution.  Many advisors thought that the rule was that the higher income earner could not open an IRA, which was incorrect. Note, that they were still able to make the contribution but simply lost the ability to deduct them.

Why would anyone open an IRA that they could not deduct?  Well, it still allowed tax-deferred growth after it was opened. It was a “tax-deferred annuity” that could be invested in any way that an IRA could be invested.  With the creation of a Roth IRA (1997) and the Roth conversion rules that developed afterward, the planning community spared no time in putting two and two together. Now we could convert the “excess” IRA contribution that had never been deducted into a Roth IRA. The future growth would be “tax-free” instead of “tax differed”.  Some refer to this as a “Back-Door Roth”. This allowed a way for Roth contribution for people who would previously not have been allowed to contribute.

With some of the changes in the new tax code, the planning community wondered if that ability had been forfeited.  The ruling came down in favor of allowing that to continue.

So, at least that part of the planning race is over until 2025!

The changes to the tax code have left bits and pieces like this for clarification that will take years to decipher.  Even grander in scope are new sections of the code like 199A, and new terms of art like “QBI” (Qualified Business Income) that will need to be further defined.  That endeavor will take so much time that several years of business returns will be filled without reliable guidance, so battles over letter audits will likely continue until 2025 and after.  Then, it all sunsets and goes away. We are back to the 2017 tax code. Right about the time we actually understand what we’re doing and reframe our business tax practices.

What should the Trump tax code be nicknamed?  “Finish Line 2025”!  Or, “The Constant Confusion of the American Taxpayer Act”.

So, if you have never used a tax planning firm in the past and have just used tax preparation firms, you may want to rethink that. If you need proof, consider that H&R Block just announced the closing of 400 offices and their stock has dropped significantly in value as a result.

“Plan Early and Plan Often!”™