457(b) and its early access rule

In short

A friend of mine worked for his county for thirty years and never once thought about how his savings could be reached. If you work for a public school, a city, or a state agency, you may have a 457(b) plan, and its exit door is wider than most people guess. A governmental 457(b) does not charge the usual 10 percent early withdrawal penalty when a worker leaves the job and takes money out. Ordinary income tax still applies to every dollar that comes out of a traditional balance. The yearly limit on what a worker can put in is the current figure, which the official source publishes each year, and the plan document says whether a catch up is offered. Read your own plan's rules on leaving, because each employer writes its own. Early access is a convenience, not a reason to spend retirement money.

The whole of it

What it is

I once watched a retired bus driver explain his savings to a neighbor over a fence, and he called it his county account, as if it were a jar on the shelf. That is a fair picture. A 457(b) is a retirement savings plan offered by state and local governments and by some nonprofit groups. A worker chooses to set aside part of each paycheck, and the plan holds it until the worker is ready to use it.

There are two main kinds, and the difference matters a great deal. A governmental 457(b) is run by a state or local government, such as a school district, a city, or a county. A nonprofit 457(b) is offered by certain tax exempt organizations. The early access rule is the real gift of the governmental kind, and the nonprofit kind does not share it in the same way. The Internal Revenue Service describes both on its pages about 457(b) plans, and the statute behind them is Section 457 of the Internal Revenue Code.

Most retirement plans punish a withdrawal before a certain age. A 401(k) or an IRA usually adds a 10 percent penalty on top of the income tax when money comes out early. A governmental 457(b) is built differently. Once a worker separates from service, meaning the job ends for any reason, the money can come out without that extra 10 percent. The tax on the income remains. So the door is open, but it is not free.

How it works

You have probably heard someone say that a retirement account is locked up tight until age 59 and a half. For a governmental 457(b), that is only partly true. The age of 59 and a half is not what unlocks the money here. Leaving the job is.

Think of it in three steps. First, the worker contributes from each paycheck, either before tax or, if the plan allows, as a Roth contribution. Second, the money sits in the plan and grows or shrinks with whatever the worker chose inside it. Third, when the worker separates from the employer, the plan may let that worker take money out. The plan must allow it, and the worker must ask. No automatic payout happens.

Here is the part people miss. While a worker is still employed, the plan can usually not hand over money before the worker reaches age the current figure, which the official source publishes each year, apart from a narrow set of cases. The plan document names those cases. A true emergency is one of them in many plans. The law defines an unforeseeable emergency, and the plan decides whether to offer it. The plan requires its own paperwork, and the plan administrator makes the call.

Another small point. Money rolled into a governmental 457(b) from an IRA or a 401(k) can carry its old penalty rules with it. The penalty free treatment applies to the money that was earned inside the 457(b) itself. A worker who rolled other money in should ask the plan to keep those pieces separate and show the balance of each.

Tax follows the same plain road. Money that went in before tax comes out as ordinary income. A Roth balance, if the plan has one, follows the Roth rules, which the IRS explains on its Roth pages. The plan reports each payout on a Form 1099-R, and the tax is due with that year's return.

The numbers, and where to find yours

I know a woman who kept her plan papers in a drawer for a decade and was glad she had when it came time to retire. Hold on to yours, because three numbers decide a lot. The first is the yearly contribution limit, which is the current figure, which the official source publishes each year. The second is the age at which the plan may let a working person take a payout, which is the current figure, which the official source publishes each year. The third is the age for a catch up, if the plan offers one, which is the current figure, which the official source publishes each year. The IRS sets these by law and updates them by year, so the site shows the verified figure with its source and date.

Where do you find your own facts? Start with the summary plan description, which the employer must give a participant on request. It states whether the plan is governmental, whether it allows Roth money, and when a payout can begin. Then check your latest statement for the balance and its pieces. The IRS publishes its rules on the page for retirement plans for governments, and Section 457 of the tax code is the law underneath. When the plan and the general rule seem to differ, the plan document wins on what that plan permits.

A worked example

Let me tell you about a man named Daniel, who worked eleven years for a county road department. He earned $52,000 a year. Each year he set aside 6 percent of his pay, which is 6 percent of $52,000, or $3,120. Over eleven years, that came to 11 times $3,120, or $34,320 in contributions. Say the account grew, and his balance on his last day stood at $41,000.

Daniel left for a private sector job at age 44. He asked the plan for a payout of $10,000 to cover a roof repair. Because he had separated from service and the money was earned inside the governmental 457(b), the extra 10 percent penalty did not apply. Had it been an early withdrawal from a 401(k), the penalty alone would have been 10 percent of $10,000, or $1,000.

The tax is another matter. The $10,000 counted as ordinary income. Suppose Daniel's tax rate on that slice was 22 percent. Then the tax was 22 percent of $10,000, or $2,200. He kept $7,800, because $10,000 minus $2,200 is $7,800. The plan might also withhold some tax at the time, which only matters at filing. The $10,000 did not go to waste, but it did leave the account, and $10,000 gone at age 44 can shrink a future balance by a good deal more than $10,000.

That last point is the quiet cost. If $10,000 had stayed in and grown, it could have become a much larger sum by the time Daniel reached his sixties. The rule let him reach the money. It did not make reaching it cheap.

Where it goes wrong

I have seen a good man make a small slip that cost him real money, and he never saw it coming. The first trap is mixing up the plan types. A nonprofit 457(b) does not give the same penalty free access, and a worker who assumes it does can be surprised. Check which kind you have.

The second trap is the rollover. Say a worker moves a 457(b) balance into an IRA, thinking the flexibility will carry over. It does not. Once the money lands in an IRA, the usual early withdrawal penalty can apply to it again. The same goes for a rollover into a 401(k). Leaving the money in the 457(b) keeps the penalty free door open.

The third is the tax bill. A payout is income, and a large one can push a person into a higher bracket for the year. People forget that. They plan for the penalty they will not owe and miss the tax they will.

Fourth, the employer. The plan, not the law alone, sets the rules for taking money out. A county may allow only certain payout forms, or may wait to process a request. Ask first.

And last, the plain temptation. An open door tempts a person to walk through it. Retirement money is meant to last. Treat the access as a safety net for a real need.

Questions to answer before you leave this page

Do you know whether your plan is a governmental 457(b) or a nonprofit one, and where in your papers it says so? Have you read the summary plan description to learn when your plan lets a worker take a payout, and what paperwork it requires? If you left your job tomorrow, would you want the money to stay in the plan, and have you weighed that against a rollover that could bring the 10 percent penalty back? Could you afford the income tax on a payout, and would it push you into a higher bracket that year? Is there a Roth piece in your account, and do you know how its rules differ? Have you checked the yearly limit of the current figure, which the official source publishes each year and whether a catch up at the current figure, which the official source publishes each year applies to you? And if the money does come out early, what will it cost your future self?