457 plans are a type of retirement account offered largely to certain governmental employees. We see them available typically to police officers and fire fighters as an avenue for supplemental retirement savings. The 457 is a place to accumulate retirement savings over and above your pension. As such, the 457 is a type of non-qualified deferred compensation, rather than a qualified plan that comes under ERISA (Employee Retirement Income Security Act) legislation. Please see my previous post about 457 plans here.
There were a lot of terms there, but they’re important, so let me break it down a bit. ERISA legislation determines whether an employer’s retirement plan is qualified or not. Qualified, meaning that the employee can defer income to the retirement account on a pre-tax basis. The most popular of these is the 401(K) plan. Others are profit sharing plans and money purchase plans. There are maximum deferral amounts each year ($19,500 in 2020), and maximum amounts than an employer can contribute and deduct. Employees who withdraw funds before age 55 have a 10% tax penalty on the amounts withdrawn.
Typically when people retire they roll their funds out of the employer-sponsored retirement plan into an IRA. But the IRA has the same 10% penalty for most withdrawals, but the age is now 59 ½ (there are a few exceptions).
With those two ages in mind – 55 and 59 ½ - we come to the first mistake:
When you withdraw funds from a 457 plan, no matter your age, there is no 10% penalty! Say you retire from the County at age 52, with 30 years of service, and begin to draw your pension. Your 457 funds are completely accessible to you with no tax penalty. But – if you move those dollars into an IRA, you’ve just given yourself a 10% on any withdrawals for the next 7 ½ years. Bad move! And if anyone is advising you to do so, that person is either not knowledgeable, or not giving advice in your best interests, or perhaps both.
What’s the strategy then? Lots of people want to retire in their 50's. Ideally, you would see a financial planner way back when you first began thinking about retirement. You’d think about a retirement age, and work on a cash flow worksheet for that retirement. If you have a pension and can live on that until your Social Security comes (age 67 is now the full retirement age), then great. In our example you’re going to need to withdraw from your retirement account for those 15 years until Social Security kicks in. The absolute last thing you want to do with your 457 funds is put them in an IRA. Leave it alone! Withdraw funds as needed and pay no 10% tax penalty.
I am not a fan of annuities as accumulation vehicles. Please see our blogpost Why I Don’t Like an Annuity in an IRA. Annuities themselves are used as both accumulation and distribution vehicles. As accumulation vehicles, they offer the advantage of tax-deferral. But in your 457 you already have tax-deferral. So why would you want to take on an annuity surrender schedule of 5-10 years for a benefit you’ve already got? If someone is pitching an annuity to you for your retirement money, you are dealing with a commissioned salesperson, rather than a professional financial planner who is held to a fiduciary standard of client care. There’s a big difference.
If you’ve already made the mistake and rolled your funds over into an IRA that is funded by an annuity, you can undo the transaction but it will take several years. Annuities typically have a 10% free annual withdrawal amount – that is, any money you withdraw during the surrender period that exceeds 10% of the account value will incur a surrender charge to the annuity company. You can open another IRA, and transfer the 10% distributions until the surrender period is over. You can then engage a professional money manager for the IRA, but you’re still subject to the age 59 ½ tax penalty.
Please see my previous two blog posts about annuities for more information: Part I the Accumulation Phase and Part II the Distribution Phase. The point is that annuities are tools designed to do a certain job, just as any other tool on your workbench or in your kitchen is designed for a certain function. But they are sold on commission – typically 3% to 7% - and consequently there is a huge conflict of interest between you and the salesperson. And yes I know the pitch: you’ll never lose a cent. You participate in the market gains but never the losses. True. But remember: the house always wins. The products are structured to produce a profit for the issuing company. Best to hire a competent investment manager.
Planning a retirement - particularly an early retirement - is serious business. You should be working with a CERTIFIED FINANCIAL PLANNER™ professional. Please feel free to get in touch with us at [email protected] Also follow us LinkedIn, Facebook, Instagram, and YouTube for more personal financial information relevant to you!
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