When saving for a retirement, there are multiple tax-advantaged employee plans which are available right now. Two of the most common plans that are used are the 401k retirement plan and the 457 deferred compensation retirement plans.
The 401k plan is the most common type of plan which uses deferred contributions to help employees save for a retirement. It is a qualified retirement plan under the ERISA (Employee Retirement Income Security Act) of 1974.
That is the main difference that a 401k has over a 457 deferred plan. ERISA rules do not apply to 457 accounts, which means there is no tax assessment of a penalty should an early withdrawal occur. For participants, that means there is less of a threat to pay a 10% tax penalty on the amount distributed, in addition to the income tax requirements that would be enforced on the amount received.
Here are some of the other differences to consider between the two plans.
401k and 457 Plan Differences
1. 457 plans feature a double-catch up provision.
If you are nearing the age of retirement, the 457 plan allows you to double the catch-up amount that a 401k plan offers. Each tax year offers the potential of a different maximum, but in 2017, that amount was $6,000. Under the right conditions, someone with a 457 plan would be able to contribute up to $35,000 to their plan in one year.
2. Qualifications for early withdrawals are different.
Both the 401k and 457 plans allow for an early withdrawal under specific circumstances. How that qualification occurs is different between the plans. In a 401k, you are permitted an early withdrawal only if you have a qualifying financial hardship. Each 401k plan defines what qualifies for such a hardship. With the 457 plan, an unforeseeable emergencies allow for hardship distributions, of which the exact circumstances must be outline in the plan language.
3. 457 plans allow independent contractors to participate.
Another important difference between these two plans is that the 457 deferred plan allows independent contractors to participate in them. This is seen most often when there is a public 457 plan or a non-profit 457 plan that is being used. There are 401k plans for those who are self-employed, but the typical 401k plan does not allow independent contractors to participate in the plan.
4. There is an increased salary reduction limit available for 457 plans.
If an employee is in their final 3 years of work before reaching the normal age of retirement, then the lesser of the following two rules applies. The employee can contribute twice the applicable dollar limit or the applicable dollar limit, plus the sum of unused deferrals in prior years. The age 50 catch-up rule contributions are not counted for this purpose at all. The option for increased limits does not exist when using a 401k plan.
5. The 457 plan may limit the amount of includible compensation.
When employees are saving money in a 401k retirement plan, they receive a salary reduction up to a maximum of the capped limit for the tax year. In 2018, that limit is scheduled to be $18,500 at the time of writing. With a 457 plan, the lesser of two amounts applies. You can either save the capped maximum for the year or contribute 100% of the includible compensation. In other words, with a 457 plan, if you only make $10,000 per year, then that is the maximum you’re allowed to contribute to the plan.
6. There are timing differences for when contributions are permitted.
When saving into a 457 deferred retirement plan, the time of the election to make a salary contribution is before the first day of the month where the compensation is either paid to the employee or made available. With a 401k retirement plan, the decision must be made before the compensation is paid or made available, but it is no less frequent than an annual decision.
7. There are distributable event differences.
In the 457-plan, participants reach the age of attainment at 70.5. For the 401k retirement plan, the age of attainment is 59.5. Both plans allow for distribution should there be a severance from employment or the plan is terminated. What makes the 457-plan unique is that small account distribution is also permitted, although the amount cannot exceed $5,000. A qualified domestic relations order allows for the distribution of funds from a 457 as well. In the 401k plan, death or disability are listed as distributable events, whereas the domestic order must cover this issue for the 457.
8. A 457 plan allows for corrections.
In the 457, there is an available statutory period to correct the plan should it fail to meet is applicable requirements. The period is available until the first day of the plan year, which begins more than 180 days after the IRS has notified the plan about the failure. This option is not permitted with the 401k retirement plan at all.
Both the 401k and the 457 plans allow employees to make contributions to trust. Loans are possible, which are not treated as a taxable distribution to the participant, are possible as well. Although the differences are somewhat minor in many ways, understanding what makes these retirement plans different will help you to know which one can provide the most benefits.