How Is a 457b Plan Taxed

A 457b plan is a type of deferred compensation plan offered by certain employers, including state and local governments and tax-exempt organizations.

Contributions to a 457b plan are made with pre-tax dollars, which means they are deducted from your paycheck before income taxes are applied.

This reduces your taxable income for the year, which can lead to lower federal income taxes owed.

The money in your 457b plan grows tax-deferred, meaning you won't pay taxes on investment earnings until you withdraw the funds.

A fresh viewpoint: 457 Plan vs 401k

A 457 plan is a tax-deferred compensation plan created under Section 457 of the Internal Revenue Code. It's designed to help employees of non-profit institutions and public schools save for their supplemental retirement income.

The federal government created the tax-deferred advantages for 457 contributions to encourage employees to save for retirement. This means you can set aside money for retirement on a pre-tax basis through a plan offered by your employer.

For your interest: 457b Plan Explained

Any contracted employee of the Foothill-De Anza College District is eligible to participate in the plan through a payroll deduction. This includes employees who work for the district, but may not be full-time staff.

The plan allows you to contribute up to $23,000 per year, with an additional $7,500 allowed if you're 50 or older by the end of the year.

A 457b plan is taxed differently depending on the type of plan and the employer sponsoring it. For nongovernmental 457(b) plans, distributions are not subject to 20% income tax withholding, but the plan may provide for a direct trustee-to-trustee transfer to another tax-exempt organization.

In contrast, governmental 457(b) plan distributions that qualify as eligible rollovers are subject to 20% income tax withholding unless directly rolled over to another plan or IRA. Distributions not considered eligible rollovers are subject to 10% withholding unless the participant elects to waive withholding.

For tax-exempt 457 plans, distributions are taxed as wages in the year paid, and the plan administrator must withhold income taxes in the same manner as other wages. This means distributions are reported on Form W-2 and withholding on Form 941.

Distributions from a 457(f) plan, which is a nonqualified deferred compensation plan, are subject to income tax in the first year the compensation is no longer subject to a substantial risk of forfeiture. This means the full present value of any deferred compensation is included in income tax in the first year it vests.

A fresh viewpoint: What Is 1099 Tax Form

You can make significant contributions to a 457(b) plan, especially if you're over 50. An eligible participant of a governmental 457(b) plan who is over age 50 by the end of the calendar year could qualify for an additional catchup contribution of $6,500 in 2022.

A governmental 457(b) plan can provide for an age 50 catchup contribution, while a nonprofit 457(b) plan can only provide for special catchup contributions. These special catchup contributions can be as high as the normal annual deferral limit ($20,500 for 2022), but are limited to unused deferral limits from previous years.

Participants who previously deferred the maximum amount into a 457(b) plan every year would not be eligible to use this special catchup.

For another approach, see: Tax Deferred Contribution

Elective deferrals are a type of contribution to a retirement plan that aren't subject to income tax withholding in the year of deferral.

Elective deferrals can include nonelective contributions made by the employer, which is a key aspect of 457(b) plans.

Catchup Contributions are a great way to boost your savings in a 457(b) plan. Two types of catchup contributions are potentially available, if provided for in the plan document.

Governmental 457(b) plans may offer an age 50 catchup contribution, similar to those permitted under 401(k) and 403(b) plans. This allows eligible participants over age 50 to qualify for an additional catchup contribution of $6,500 in 2022.

Both governmental and nonprofit employers can allow for a "special" 457(b) catchup contribution in the three years prior to normal retirement age. This catchup feature can be as high as the normal annual deferral limit of $20,500 for 2022, but is limited to unused deferral limits from previous years.

Participants who previously deferred the maximum amount into a 457(b) plan every year would not be eligible to use this special catchup.

Distributions from a 457(b) plan are subject to income tax withholding. A distribution from a governmental 457(b) plan that qualifies as an eligible rollover is subject to 20% income tax withholding.

If a distribution is not an eligible rollover, it's subject to 10% withholding unless the participant elects to waive the withholding. The plan administrator is responsible for withholding unless it directs the payor to withhold income taxes on the distribution.

Distributions from a 457(b) plan sponsored by a nonprofit employer are taxed as wages in the year paid. This means the plan administrator needs to withhold income taxes with respect to such distributions in the same manner it would any other wages.

Distributions are reported on Form W-2 and the withholding on Form 941. Distributions to a beneficiary are reportable on Form 1099-R and such distributions are not subject to withholding.

A 457b plan is subject to income tax, but only when you withdraw the funds.

Contributions made to a 457b plan are made with pre-tax dollars, reducing your taxable income for the year.

You'll need to pay taxes on the withdrawals, but you can roll over the funds to a traditional IRA, allowing you to delay taxes until retirement.

Explore further: Taxation on Index Funds

The Non-Duplication Rule is a crucial exception that saves taxes for both employees and employers. It prevents double taxation of FICA taxes on nonqualified deferred compensation.

Under this rule, FICA taxes are withheld only once on nonqualified deferred compensation, and not again at the time of distribution. Importantly, interest or investment gains credited to the contributions that were previously subject to FICA tax withholding are not subject to FICA taxes at distribution.

A key aspect of the Non-Duplication Rule is that it applies to 457(b) Plans, where contributions are credited to the plan many years after they are made. This can result in significant savings, as seen in an example where an executive's contributions grew from $87,000 to $205,000 over twenty years, with the investment growth of $118,000 not subject to FICA taxes.

The Non-Duplication Rule can save taxes in the amount of 7.65% (combined 15.3%) of the distribution amount related to investment option gains. This can add up to substantial savings over time, especially for long-term deferrals.

Related reading: Taxes on Deferred Compensation

Failing to follow the special timing rule in a 457(b) Plan can lead to significant consequences. If you don't adhere to the special timing rule, you'll be required to withhold Social Security and Medicare taxes under the general timing rule.

This means that not only will taxes be withheld from the deferrals or contributions, but also from any investment growth credited to the account. A court has actually held that an employer's failure to use the special timing rule resulted in a breach of contract, causing a material reduction in the net distribution of the participant's account.

The employer may be liable for the employer side of the FICA taxes and the employee's side, plus a tax gross-up payment on the value of the additional FICA taxes they pay on behalf of the employee.

Here's an interesting read: Custodial Account Taxation