How a 457(b) Plan Works: Employer-Sponsored Deferred Compensation for Public Employees

A 457(b) is a tax-deferred savings account for state and local government workers

A 457(b) deferred compensation plan is an employer-sponsored retirement savings account available to employees of state and local governments and certain tax-exempt organizations. You contribute money from your paycheck before taxes are taken out, the money grows tax-free inside the account, and you pay income tax only when you withdraw it in retirement.

The structure is similar to a 401(k), but the rules are different in ways that matter. Your employer does not have to match your contributions (though some do). You can withdraw money starting at age 59½ without penalty, but unlike a 401(k), you can also withdraw money at any age if you separate from your employer. The account is held in your name, not your employer's, which means your money is protected if your employer faces financial trouble.

The main reason to use a 457(b) is to reduce your taxable income now and let your savings compound tax-free. If you earn $65,000 and contribute $7,000 to your 457(b), you pay income tax on only $58,000 that year. That $7,000 grows without being taxed each year until you withdraw it.

Key Takeaways

• A 457(b) lets you set aside money from your paycheck before income tax is calculated, lowering your tax bill in the year you contribute.
• You can withdraw money without penalty once you leave your job, at any age, unlike a 401(k) which charges a 10% penalty before age 59½.
• Your employer does not have to contribute matching funds, though some government employers do offer a match.
• The annual contribution limit is set by the IRS and changes each year; you can check your plan documents or your employer's benefits office for the current amount.
• Money in a 457(b) belongs to you and is protected from your employer's creditors, even if the government agency faces budget cuts.

How contributions and tax treatment work

You choose a percentage of your paycheck to contribute to your 457(b), up to an annual limit. That amount is deducted from your gross pay before federal income tax is calculated. If you contribute $500 per month, your employer reduces your taxable income by $6,000 that year, which means you owe less federal income tax.

Your contributions are still subject to Social Security and Medicare taxes (FICA), so those deductions appear on your paycheck alongside the 457(b) contribution. State and local income taxes vary by location; some states tax 457(b) contributions, others do not. Check with your employer's payroll office or benefits administrator to understand how your state treats these contributions.

The money you contribute and all investment gains inside the account are not taxed until you withdraw them. If your account balance grows from $50,000 to $75,000 over ten years, you do not pay tax on that $25,000 gain while it sits in the account. You pay income tax on the full $75,000 when you start taking withdrawals in retirement.

Withdrawal rules and the separation-from-service advantage

The most significant difference between a 457(b) and a 401(k) is when you can withdraw money without penalty. With a 401(k), you cannot touch your money before age 59½ without paying a 10% early withdrawal penalty (plus income tax). With a 457(b), you can withdraw money at any age once you separate from your employer—you resign, retire, or are laid off—and there is no penalty.

This matters if you leave your government job at age 50 and want to live off your savings until Social Security starts at 67. You can withdraw from your 457(b) without the 10% penalty that would apply to a 401(k). You still owe income tax on the withdrawal, but not the extra penalty.

You can also withdraw money before separation under a "hardship" rule, though the definition is narrow. Most plans allow hardship withdrawals only for immediate and heavy financial need—medical bills, preventing eviction, or funeral expenses. Your plan documents spell out which hardships may have access to. Hardship withdrawals are taxed as ordinary income and may trigger a 10% penalty depending on your age and plan rules.

Required minimum distributions (RMDs) begin at age 73 for most people. Once you turn 73, you must withdraw a calculated amount each year, whether you need the money or not. The amount is based on your age and account balance. If you are still working for the government employer that sponsors your plan, you may be able to delay RMDs until you actually retire, depending on your plan's rules.

Contribution limits and catch-up provisions

The IRS sets an annual contribution limit for 457(b) plans. This limit changes most years to account for inflation. The limit applies to your total contributions across all 457(b) plans you participate in—if you work for two government employers, your combined contributions cannot exceed the annual limit.

If you are age 50 or older, you can contribute an additional amount called a catch-up contribution. This lets you save more in the years before retirement. The catch-up amount is also set by the IRS and changes annually. Your employer's benefits office or plan documents will show both the regular limit and the catch-up limit for the current year.

Some 457(b) plans offer a special rule called the "final three years" catch-up. If you are within three years of your plan's normal retirement age, you may be able to contribute double the annual limit (if you did not use catch-up contributions in earlier years). This is an optional plan feature, so not all 457(b)s offer it. Ask your benefits administrator whether your plan includes this option.

Investment choices and account management

Your employer selects the investment options available in the 457(b) plan. Common choices include mutual funds, stable value funds (which aim for steady, modest returns), and sometimes self-directed brokerage accounts. You choose how to invest your contributions among the available options. Your employer does not direct your investments; you do.

The investment performance of your account is your responsibility. If you choose conservative investments and earn 2% per year, that is what your account grows at. If you choose growth-oriented investments and the market declines, your account value falls. Review your investment choices periodically and rebalance if your goals or risk tolerance change.

Some 457(b) plans allow you to take a loan against your account balance. The rules and terms vary by plan. If your plan offers loans, you typically repay the loan through payroll deductions, and the interest you pay goes back into your account. Loans are not taxable events, but if you leave your job before repaying the loan, the remaining balance may be treated as a withdrawal and taxed.

Rollovers and moving money between accounts

If you leave your government job, you can roll your 457(b) balance into an Individual Retirement Account (IRA) or, in some cases, into a 401(k) at a new employer. A rollover moves the money directly from one account to another without you touching it, so there is no tax withholding and no tax due. This is different from a withdrawal, where you receive a check and have 60 days to deposit it elsewhere.

A direct rollover to an IRA gives you more investment choices than most 457(b) plans offer and may lower your fees. However, rolling into an IRA means you lose the separation-from-service withdrawal advantage. Once money is in an IRA, you cannot withdraw it before age 59½ without a 10% penalty (with limited exceptions). If you plan to retire before 59½, keeping money in the 457(b) or rolling it into a new employer's 401(k) may be better.

Not all 457(b) plans allow rollovers, and not all IRAs accept 457(b) rollovers. Before you leave your job, contact your plan administrator and ask whether a rollover is an option and what steps you need to take. Some plans require you to request a rollover within a certain time frame after separation.

Comparing a 457(b) to other retirement accounts

If you work for a government employer, you may have access to a 457(b), a 403(b) (if your employer is a school or nonprofit), or both. A 457(b) and a 403(b) have separate contribution limits, so you can contribute the maximum to each if your employer offers both. The main difference is that a 403(b) follows 401(k)-style withdrawal rules (10% penalty before 59½), while a 457(b) allows penalty-free withdrawal at any age after separation.

If you also have a 401(k) from a previous private-sector job, that account is separate. You can contribute to a 457(b) and a 401(k) in the same year, but your combined contributions to all defined-contribution plans (401(k), 403(b), and 457(b)) cannot exceed a higher IRS limit. Your employer's benefits office can explain how this limit applies to your situation.

A traditional IRA is available to anyone with earned income, but contributions are only tax-deductible if you do not have access to an employer plan or if your income is below certain thresholds. If you have a 457(b), your ability to deduct IRA contributions may be limited. A Roth IRA has no income limits for contributions, but contributions are not tax-deductible; instead, withdrawals in retirement are tax-free.

Frequently Asked Questions

Can I contribute to a 457(b) and a 401(k) in the same year?

Yes, they have separate contribution limits. However, your combined contributions to all defined-contribution plans (401(k), 403(b), and 457(b)) cannot exceed a higher annual limit set by the IRS. Ask your employer's benefits office how this limit affects your situation if you participate in multiple plans.

What happens to my 457(b) if I am laid off?

Your money stays in the account and belongs to you. You can leave it there, withdraw it, or roll it to an IRA or new employer plan. You can withdraw at any age without the 10% penalty that applies to 401(k)s, though you owe income tax on the withdrawal. Contact your plan administrator for withdrawal and rollover options.

Do I have to take money out of my 457(b) when I turn 73?

Yes, required minimum distributions begin at age 73. The amount is calculated based on your age and account balance. If you are still working for the employer that sponsors the plan, some plans allow you to delay RMDs until you actually retire. Check your plan documents or contact your benefits office.

Can I borrow from my 457(b) to buy a house?

Only if your plan offers loans, which is optional. If your plan does allow loans, you typically borrow against your balance and repay through payroll deductions. If you leave your job before repaying, the remaining loan balance is treated as a withdrawal and taxed. Ask your plan administrator whether loans are available.

What if I move to a different state and change government jobs?

Your 457(b) from your old employer stays in that plan unless you roll it over. You can roll it to an IRA or, if your new employer's plan accepts rollovers, to the new plan. Some plans require you to request a rollover within a set time after you leave. Contact both your old and new plan administrators to understand your options.