457 Plan vs. 403(b) Plan: What’s the Difference?

457 Plan vs. 403(b) Plan: An Overview

The public sector may be the last bastion of the defined-benefit plan—the old-fashioned pension funded by an employer and automatically paid to employees after retirement.

But nowadays, no single source of income may be enough to ensure a comfortable retirement; people also need to save on their own to make ends meet in retirement. Unfortunately, public-sector and nonprofit organizations don’t offer 401(k) plans to which employees can contribute. However, they can and do offer other employer-sponsored plans: the 403(b) and the 457.

The 457 Plan

There are two types of 457 plans. A 457(b) is offered to state and local government employees, while a 457(f) is for top-level executives at non-profits.

457(b)

If you have a 457(b) plan, you can contribute up to $22,500 for 2023 (up from $20,500 in 2022). You can also contribute an additional $7,500 in 2023 (up from $6,500 in 2022) if you’re 50 or older.

You can contribute even more if you are within three years of normal retirement age. You may be able to contribute as much as twice the limit if you’re within three years of normal retirement age. This amount is $45,000 for 2023, up from $41,000 in 2022. However, your maximum contribution when you are within three years of normal retirement age is the lesser of twice the contribution limit or the annual limit plus the unused annual limit from prior years.

457(f)

The 457(f) plans differ significantly from their 457(b) counterpart. They are often described as golden handcuffs because they are primarily used to recruit executives from the private sector, where the pay tends to be higher and the benefits more generous.

Under a 457(f) plan, compensation is deferred from taxation. However, this deferred compensation is subject to a “substantial risk of forfeiture,” which means executives risk losing the benefit if they fail to meet specific requirements for length of service and performance.

When the compensation becomes guaranteed and is no longer subject to the risk of forfeiture, it becomes taxable as gross income.

Unless you become the head of a nonprofit organization (NPO), you’re unlikely to run into the 457(f) plan. Because the deferred compensation is not yet paid and is sheltered from taxation, the benefits remain in the hands of the employer. Rules require that executives perform services for at least two years to receive benefits under a 457(f) plan.

If you have a 457(f) plan, there is no limit on how much income can be deferred from taxation. However, amounts deferred are subject to a substantial risk of forfeiture.

Pros and Cons of the 457 Plan

Pros

• The 457(b) allows participants to double their retirement plan contributions if they are within three years of normal retirement age. Those who fall into this category can contribute up to $45,000 in 2023 (up from $41,000 in 2022).
• You can also put in an extra $7,500 per year in 2023 (up from $6,500 in 2022) if you’re at least 50 years old.
• While other plans do not allow distributions until you are 59½ years old, your 457(b) benefits become available when you no longer work for the employer providing the 457(b) plan. Otherwise, distributions are permitted when you are 72 (or 70½ years old if you reached that age before January 1, 2020) or if needed for an unforeseeable emergency.
• If you leave your job, you can roll your account over into a Roth IRA or 401(k). This is an option for the 457(b) plan but not the 457(f) plan.

Cons

• Unlike the 401(k), the match your employer contributes will count as part of your maximum contribution. For example, if your employer contributes $9,500 in 2023, you can only contribute $13,000 unless you’re eligible for a catch-up strategy.
• There are much higher contribution limits in a 401(k) plan. For example, employer matching and employee normal and catch-up contributions are $73,500 for 2023 (up from $67,500 in 2022).
• Few governments provide matching programs within the 457(b) plan. It’s mostly up to the employees to make sure they’re saving an adequate amount.
• The 457(f) plan requires that employees stay on the job for a minimum of two years. Those who leave earlier forfeit their right to the 457(f) plan.

The 403(b) Plan

A 403(b) plan is typically offered to employees of private nonprofits and government workers, including public school employees. Like the 401(k), 403(b) plans are defined-contribution plans that allow participants to shelter money on a tax-deferred basis for retirement.

When these plans were created in 1958, they could only invest in annuity contracts. So, they were known as tax-sheltered annuity (TSA) plans or tax-deferred annuity (TDA) plans.

These plans are most commonly used by educational institutions. However, any entity that qualifies under IRS Section 501(c)(3) can adopt it.

Contribution and Deferral Limits

The contribution limits for 403(b) plans are now identical to those of 401(k) plans. All employee deferrals are made on a pretax basis and reduce the participant’s adjusted gross income (AGI) accordingly.

The annual contribution limit, also called the elective deferral, is $22,500 for 2023 (up from $20,500 in 2022). Individuals can invest an additional catch-up contribution of $7,500 for 2023 and $6,500 for 2022 if they’re 50 or over.

These plans offer a special additional catch-up contribution provision known as the lifetime catch-up provision or 15-year rule. Employees who have at least 15 years of tenure are eligible for this provision, which allows for an extra $3,000 payment a year. However, this provision also has a lifetime employer-by-employer limit of $15,000.

After-tax contributions are allowed in some cases, and Roth contributions are also available for employers who opt for this feature. Like with 401(k) plans, employers can institute automatic 403(b) plan contributions for all workers, although the employees may opt out at their discretion. Eligible participants may also qualify for the Retirement Saver’s Credit.

When calculating 403(b) contribution limits for an individual, the IRS applies them in a specific order. First, they apply the elective deferral. The IRS then uses the 15-year service catch-up provision. These are followed by the catch-up contribution. It is an employer’s responsibility to limit contributions to the correct amounts.

Rollovers

The rules for rolling over 403(b) plan balances have been loosened considerably over the past few years. Employees who leave their employers can now take their plans to another employer. They can roll their plans over into another 403(b), a 401(k), or another qualified plan. They can also choose to roll their plans over into a self-directed IRA instead.

This means employees can maintain one retirement plan throughout their careers instead of having to open a separate IRA account or leave their plans with their old employers.

Distributions

Notably, 403(b) plan distributions resemble those of 401(k) plans in most respects:

• You can start taking distributions at age 59½, whether or not you’re still working at that organization.
• Distributions taken before age 59½ are subject to a 10% early-withdrawal penalty unless a special exception applies.
• All normal distributions are taxed as ordinary income.
• Roth distributions are tax-free. However, employees must either contribute to the plan or have a Roth IRA open for at least five years before being able to take tax-free distributions.
• Required minimum distributions (RMDs) must begin at age 72. The age for RMDs was 70½ until it was raised by the SECURE Act of 2019. Investors can avoid RMDs if they roll the plan into a Roth IRA or other Roth retirement plan. Failure to take a required minimum distribution will result in a 50% excise tax on the amount that should have been withdrawn.
• Loan provisions may also be available at the employer’s discretion. The loan rules are also mostly the same as those for 401(k) plans. Participants cannot access more than the lesser of $50,000 or half of the plan balance. Any outstanding loan balance not repaid within five years is treated as a taxable or premature distribution.

Distributions are reported each year on Form 1099-R, which is mailed to plan participants.

Investment Choices

Investment options in 403(b) plans are limited compared to other retirement plans. Funds can be invested in an annuity contract provided by an insurance company or in a mutual fund via a custodial account.

This situation is a source of ongoing debate in the financial and retirement planning community. Annuities are tax-deferred vehicles in and of themselves, and there is no such thing as double tax deferral.

Most plans now offer mutual fund choices as well, albeit inside a variable annuity contract in most cases. But fixed and variable contracts and mutual funds are the only types of investments permitted inside these plans.

Miscellaneous Issues

Importantly, 403(b) plans differ from their 401(k) counterparts in that, in theory, the contributions are immediately vested and cannot be forfeited. In practice, however, employers can make contributions to a separate account and, as benefits vest, retroactively apply them to the 403(b) plan.

In addition, due to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, 403(b) plans also now receive the same level of protection from creditors as qualified plans.

Plan participants should also be aware of all the fees charged by their plan and investment providers. The plan administrator must provide all plan participants a complete breakdown of these fees.

The Bottom Line

If you need more time to put aside money for retirement, a 457(b) plan is best for you. It has a better catch-up policy and will allow you to save more money for retirement.

A 403(b) is likely your best bet if you want a larger array of investment options. However, there’s a third option for some people—if you’re eligible for both plans, you can split your contributions between them.

That means you can put away $45,000 in 2023 (up from 41,000 in 2022) between the two plans, not including any catch-up contributions if you’re eligible. This might appeal more to those with higher incomes who are trying to reduce their taxes.