This article originally ran on August 29, 2014.
By David Blask
Back in 2002, public school employees eligible to contribute to either a 403(b) plan, or to a 457(b) plan, found themselves unable to contribute to both without negative ramifications. Thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001, the coordination requirement for the two plans was repealed and employees who were financially able to could contribute the maximum to both. The two plans differ in several important ways and the question, “which plan is best for me?” produces different answers depending upon an employee’s particular situation.
We have recently heard of examples of states sponsoring a state-run 457(b) plan mandating all salary deferrals first be contributed to the 457(b) plan before any contributions are allowed to the 403(b) plan. This seems like a questionable policy that may have unintended consequences for employees since the universal availability rule under Code Section 403(b)(12)(A)(ii) prohibits the conditioning of an employee’s right to participate on the 403(b) plan on another action such as prohibiting that participation unless employees first maximize contributions to the 457(b) plan.
It is also worth understanding the differences between 403(b) and 457(b) plans.
The first difference is an advantage that sets 457(b) plans apart from most other types of retirement plans. Because these plans were first established to cover public workers such as police and fire personnel, positions whose physical demands frequently result in employees retiring at an earlier age than they would in other professions, there is no penalty for taking distributions earlier than age 59-1/2. A 30-year-old taking a distribution from his or her 457(b) plan pays only ordinary income tax; there is no 10% penalty. That would seem to constitute a clear advantage for the 457(b) plan.
But it’s not that simple. In general, it is easier to get a distribution from a 403(b) plan while still employed than from a 457(b) plan. The reason is that in-service distributions under the “hardship” rules are more lenient than the higher “unforeseeable emergency” standard imposed on 457(b) plans. A participant making salary deferrals who anticipates needing to tap the retirement plan to help cover college tuition may be better off deferring into a 403(b) plan. Another example may be someone anticipating buying a primary residence a few years down the road. Assuming he or she is still employed at the time, the 403(b) plan will allow a distribution whereas the 457(b) plan won’t.
Both plans can offer loans, so the issue arises when the participant needs the distribution to cover a cost he or she can’t repay.
There are other differences, such as the special catch-up provisions in a 457(b) plan which may allow for substantially higher contributions in the three years before normal retirement age. But that provision seems unlikely to influence a younger employee’s deciding which plan he or she prefers.
The bottom line is that employees need to be allowed to decide which plan makes the most sense for them. A mandate forcing contributions into the state-run plan seems designed to provide an advantage only to the approved investment provider, not to rank-and-file employees. If you live in a state that has enacted such a provision, it might be a good time to contact your state representative and explain the unintended consequences of such a provision.
David Blask is a Senior Pension Consultant at Lincoln Investment.