What Is a 457K Retirement Fund?

A 457 retirement fund is a deferred-compensation arrangement for employees of state and local governments and certain tax-exempt organizations. Most 457 plans have tax benefits similar to those in the 401k retirement plans that many private employers offer--and it's because of that similarity that they are sometimes mistakenly referred to as "457k" plans.

Types

A 457 plan can be either "qualified" or "unqualified." These terms refer to whether the plan can take advantage of certain tax benefits--qualified plans can, unqualified plans cannot. Qualified plans are known as 457b plans, after the section of the Internal Revenue Code that defines them. Unqualified plans are known as 457f plans. An employer can offer both kinds.

Qualified 457b Plans

In a qualified 457b plan, you have a portion of your income "deferred" into an investment account before you have to pay taxes on it; your employer can also kick in money to match all or a portion of your contributions. Investment profits earned in the account are also tax-free. When you withdraw money later on, such as at retirement, that money is taxed as regular income.

The amount of income you can defer is limited, though. As of 2010, the limit was $16,500 a year, but individual plans may allow workers over age 50 to defer more to "catch up" before retirement. Depending on plan rules and how close they were to retirement, such employees could defer as much as $33,000 a year.

Vesting

In a typical deferred-compensation plan, including a 457b, you have to participate for a certain amount of time before you are "vested"--that is, until the full balance of the account belongs to you. For example, an employer could require you to be in the plan for three years before you're fully vested. If you quit your job before then, you could lose everything beyond the amount you actually put in. Regardless of when you are vested in a 457b, though, you still don't pay taxes on the money until you take it out.

Unqualified 457f Plans

A 457f plan is similar to the 457b in that you can defer pretax income into an investment account, where profits are also untaxed. The advantage to the 457f is that the amount you can defer is unlimited, as is the amount your employer can contribute. But there's a catch--or, rather, two catches: First, if you leave before you're vested, the employer can keep all the money. Second, once you are vested, the full balance of the account becomes taxable--even if you haven't made any withdrawals. The 457f plan with delayed vesting is commonly used as a "golden handcuff," an incentive to ensure that key workers stay in the organization for several years.

Withdrawals

You can take money out of a 457 plan in three cases: when you reach 70 years, 6 months of age; when you leave the employer; or when you experience certain financial hardships, including medical expenses, funeral expenses, damage to your home, eviction or foreclosure. One key advantage of 457 plans over 401k plans is that you do not have to pay any penalty if you take the money out simply because you are leaving your job. In 401k plans, any withdrawal before age 59 1/2 that doesn't qualify as a hardship withdrawal is subject to a 10 percent penalty.

References

• Cornell University Law: U.S. Code: Deferred Compensation Plans of State and Local Governments and Tax-exempt Organizations
• The Motley Fool: Retirement Plan Primer
• PlanSponsor: Deferred Compensation: Forfeiture Cause
• Quatloos: Financial and Tax Fraud Education Associates: Deferred Compensation Plans
• 457bwise: FAQ