Should I Contribute to the Retirement Plan at Work? (Part 3)
Continuing from Part 2, here are a fifth and sixth scenario in which it might make sense to contribute to a workplace retirement plan.
(5) It’s a 457(b) (“Deferred Comp Plan”)
Despite their overwhelming similarities, the 401(k), 403(b), 457(b), and TSP aren’t entirely the same. Nowhere is this more apparent than when it comes to the issue of early withdrawal penalties. With the vast majority of workplace retirement plans (as well as all IRAs, including the Roth IRA), the tax code imposes a penalty for cashing money out before the age of 59½. If the withdrawal is from a pretax account, the penalty is an extra tax equal to 10% of the amount withdrawn. If the withdrawal is from a Roth account, and that withdrawal includes money that was earned inside the account, then the penalty is twofold: those earnings end up not being tax-free, plus you’re on the hook for an extra tax equal to 10% of those earnings! (If the withdrawal only contains money that you yourself contributed, you’re off the hook for any taxes.) And while no one can stop you from dipping into an IRA (of any type), in the case of a workplace retirement plan, as long as you’re working for the employer who sponsors the plan, you most likely won’t even be allowed to make a withdrawal before you turn 59½. You might be able to take out a loan against your account in the plan, but you’ll be expected to pay it back within 5 years. (By the way, if you’re contemplating a loan from your 401(k), etc., be aware that if you cease to work for that employer before having paid back the loan in full, then even if they were the ones who let you go, the outstanding loan balance gets added to your tax bill for that year and, if you’re not yet 59½, may also be subject to the early withdrawal penalty.) However, among workplace plans, there is one exception to the standard bias against people younger than 59½: the 457(b). As soon as a participant of a 457(b) plan parts ways with the employer, they’re free to tap into that money, no matter how young they are. No extra 10% to pay.
To illustrate the profound implications of this fact, let’s say that you’re a firefighter who’s investing in two personal brokerage accounts (one a Roth IRA, the other an unsheltered joint account with your spouse). And let’s say that after 20 years with the fire department, you’ve decided to retire at the ripe old age of 45. Let’s also say that over those 20 years with the department, you had a portion of every paycheck sent to your 457(b) as a pretax contribution. What this means is that you now have a pool of money that’s been accumulating for 20 years without costing you anything in taxes (in fact, it’s lowered your tax bill for each of those 20 years), and you now can tap into it without being penalized for being “too young”. This pool of money can help you bridge the gap until you reach 59½, the age at which you'll be able to start pulling money from your Roth IRA tax-free. What’s more, by drawing money from your 457(b) account, you’re giving your other money (inside your Roth IRA and joint brokerage account) more time to grow in an environment in which there's more investment freedom (although that freedom comes with the responsibility to put a dependable trading/investing system in place, whether it’s your own, a professional who advises you, or a professional who manages the money for you). Furthermore, retiring at 45, you have plenty of time to spend down that 457(b) at your own pace, controlling how much of that money you get taxed on each year. By the time you turn 70½, you might have little or nothing left for the IRS to force you to withdraw according to their timetable. Not that you’ve run out of money – it's just that you’re relying more on your Roth IRA and joint brokerage account, both of which you can spend down at your own pace!
So, if your workplace offers you a 457(b) and you think you might leave there well before you turn 59½, consider making pretax contributions to that 457(b). Note that they need to be pretax; if you cash money out from an old Roth 457(b) account before you turn 59½, then there won’t be a 10% penalty tax, but if the withdrawal includes money that you earned inside the account, those earnings will be taxable – which defeats the whole purpose of making Roth contributions in the first place! Also, beware that if you roll money from a 457(b) over to a different type of plan (a 401(k) at a new job, an IRA, etc.), that money loses its protection from the extra 10% penalty tax. Going back to our example of you retiring at 45, if you roll your 457(b) money into an IRA, you’ll effectively cut yourself off from accessing those funds until you’re 59½! Be sure to bring this up if someone tries to convince you to move money from an old 457(b) plan before you’ve reached that “magic” age of 59½.
Two other points about 457(b) plans. First, if you roll money into a 457(b) from an old 401(k) other plan that is subject to the early withdrawal penalties, then that money, as well as any money you make on it, will continue to be subject to those penalties. In other words, the government doesn’t want you using your 457(b) as a backdoor to “liberate” other pretax or Roth money from early withdrawal penalties! Second, while the 457(b) is advantageous compared to other plans for those who leave the employer before age 59½, it's disadvantageous compared to other plans for those who stay with the employer past age 59½. You see, with the TSP and many 401(k) & 403(b) plans, once you turn 59½, you have the option to pull money out of the plan even while you’re still working for that employer. I don’t mean taking a loan; I mean permanently moving money out of the plan. This is known as an in-service distribution, and its chief appeal is that it gives you the freedom to take that money and invest it how you see fit (instead of being limited to what the plan has to offer you) - all while still being able to contribute to your employer's plan (which you might want to do in order to take advantage of the higher contribution limits, employer match, etc.). But 457(b) plans don’t allow in-service distributions; you won’t be able to move that money until you separate from the employer.
One last note: all of the references to 457(b) plans above and in other parts of this multi-part post apply only to governmental 457(b) plans. In other words, your employer has to be some sort of government below the federal level (state, county, city, etc.), or an organization that’s part of such a government. Typical examples include first responders (police, firefighters, etc.), folks who work at city hall, and faculty and employees of state college/university systems. If you have a 457(b) from a non-governmental entity, then it’s a “non-qualified deferred comp plan”, in which case your contributions are neither tax-deductible nor protected in the event your employer declares bankruptcy. (In contrast, governmental 457(b) plans, as well 401(k) and 403(b) plans, enjoy legal protection from bankruptcy - both yours and employer’s.) If you’re not sure if your 457(b) is governmental or not, check the plan’s literature.
(6) You’re in the military and are deployed to a combat zone
If you’re a member of the armed forces and are deployed to a combat zone, then some or all of your pay during that time is tax-exempt. You get to deduct it from your tax bill for that year. (See here for more detail.) What’s more, if you use that tax-exempt pay to make contributions to your Roth TSP account, the money earned on those contributions will also be tax-free! (Of course, this assumes that you wait long enough before pulling out those earnings: until you’ve turned 59½ and 5 years have passed since your first Roth TSP contribution.) This is one of only a few scenarios I can think of in which money can come into your hands without any legal obligation to pay taxes on any portion of it. I should also mention that you could achieve the same effect by contributing tax-exempt combat zone pay to a Roth IRA, but remember from Part 2 of this post that you may be able to contribute a lot more of your pay to your Roth TSP account than to a Roth IRA.
By the way, as far as I can see, there’s zero advantage to contributing tax-exempt combat zone pay to your pretax TSP account, because that pay is already tax-deductible anyway, and the money you earn on it in the pretax account will be taxable when you pull it out and will also be subject to RMDs (required minimum distributions) later in life.
Well, that's six scenarios down, two more to go! Stay tuned!