How a 457 Plan Works

Similar to qualified retirement plans, the mechanics of participating in a government or Code Sec. 457 plan are fairly straightforward. An eligible employee contributes as much as possible to the 457 plan and the contributions, plus interest, grow tax-free until distributed from the employee's account. To take advantage of the benefits of tax deferral, a 457 plan must meet the following requirements:

• The plan must restrict participation to individuals who work for a state or state subdivision or certain tax-exempt nongovernmental organization.
• The maximum annual amount of compensation that an employee can generally defer under a 457 plan in 2013 and 2014 is the lesser of $17,500 or 100 percent of the employee's compensation. (The amount may be indexed annually for inflation.)
• The plan must provide that a deferral for a given month will not be made unless an agreement has been entered into before that month begins.
• The plan must meet the minimum distribution rules.
• Amounts deferred under a 457 plan maintained by a state or local government must be held in a trust, a custodial account, or an annuity contract for the exclusive benefit of plan participants and their beneficiaries.

Warning The trust requirement that applies to state and local government 457 plans does not apply to a tax-exempt organization that is not a governmental entity. This means that those who participate in a tax-exempt organization's 457 deferred compensation plan run the risk that their employer may not have sufficient funds to pay a participant when it comes time for distributions from the plan. For similar reasons, the rules for rollovers and distributions from nongovernmental 457 plans are not friendly to the plan participants. If you work for a tax-exempt employer that is not a government entity, these factors may cause you to reconsider whether you want to participate in the plan. Perhaps a better alternative for you would be to make contributions to an IRA instead--although the annual contribution amount for an IRA is far lower. Another option would be to lobby for your employer to establish a 403(b) plan, which is akin to a private-employer's 401(k) plan.

For a tax-exempt organization that is not a governmental entity, the plan must provide that all compensation deferred and all earnings on that compensation remain the property of the employer, subject to the employer's general creditors, until paid out to plan participants.

Tip A 457 plan may authorize loans to plan participants. To avoid treatment as a taxable distribution, however, the loan must have a fixed repayment schedule, charge a reasonable rate of interest, and be executed according to the repayment safeguards imposed by prudent lenders. These requirements are the same as those for loans from qualified plans.

Increased contributions. The tax law allows those who are at least 50 before the end of the plan year to make increased catch-up contributions to help those nearing retirement to save more. In 2013 and 2014, an eligible 457 plan participant can contribute an additional $5,500. This amount may be adjusted annually if warranted by inflation.

Tip Don't forget about the retirement savings tax credit available to low- and middle-income taxpayers. This credit provides an immediate tax break on top of the other tax advantages for contributing to a retirement plan.

Under another special "catch-up" rule that applies only to 457 plans, a 457 plan participant may make increased contributions to the plan during the last three years before retirement. The increased contribution amount is twice the otherwise applicable dollar limit for the year. However, the catch-up provision for those age 50 and over does not apply during this period. Contributing twice the dollar limit more than makes up for the loss, though.

Example Jebediah (Jeb) Shrub is a state government employee and a participant in a 457 plan. Jeb retired at the end of 2013 when he was 65. The maximum amounts Jeb could contribute each year in the three years prior to retirement are as follows: Contribution Limits 2011 annual limit $16,500 pre-retirement catch-up contribution 16,500 2011 total $33,000   2012 annual limit $17,000 pre-retirement catch-up contribution 17,000 2012 total $34,000   2013 annual limit $17,500 pre-retirement catch-up contribution 17,500 2013 total $35,000