The Magic of the Pre-Tax 457(b) Plan if you Qualify

What is the heck is a pre-tax 457(b) plan retirement account?-

The pre-tax 457(b) plan can help you next level your journey to Financial Independence (FI). A 457(b) financial planning device is only open to a select number of individuals.  The IRS allows 457(b) plans for certain government and non-governmental tax-exempt entities for select employees with higher earnings.  Additionally, 457(b) contributions are beyond the normal 403(b) contributions. This is where the magic happens.

The following post is not financial advice so here is my disclaimer: please check with your accountant, financial planner, and your employee benefits person to determine if such a 457(b) plan exists if you work in state or local government or a non-governmental tax-exempt entity.  Further, make sure participation in such a plan is right for you and your situation.

If you qualify for a pre-tax 457(b) plan, it is best to review this IRS document and guidance.  Please feel free to discuss this option with your employer if you work in a non-governmental tax-exempt entity.  Your human resource professionals may not be as familiar with this type of pre-tax 457(b) plan.   457(b) plans are for high-income earners.  However, this definition is somewhat nebulous even according to the IRS.   According to the IRS, “…there is no formal legal definition of a ‘select group of management or highly compensated employees…” However, “it generally means… key management employees, or earn a salary substantially higher than that of other employees.” Advocacy by of one of the employees at one of our non-governmental employers, the organization created a 457(b) plan.

Tax Advantages of the 457(b) Plan

Serious magic is found in the tax advantage of the 457(b) plan. Eligible employees making contributions to a 457(b) plan do so before you pay taxes on it (more on this below).

            Individuals eligible for a 457(b) plan are able to contribute up to is $23,000 to a non-governmental plan in 2024.  As I understand it, only governmental plans allow for the age 50 and older “catch-up” contribution. If you are 50 or older, your plan may allow you to contribute an additional $7,500 as a “catch-up” contribution. This means if you are age 50 or older, your total contribution can be as high as $30,500 annually. 

            Further, another aspect of the 457(b) plan for non-governmental tax-exempt organizations is that your employer cannot contribute to these funds.

            There are several key aspects to the establishment of such 457(b) plans by your employer.  The IRS has very specific rules regarding the establishment of a 457(b) plan. If the employer does are not followed these rules it can be tax disadvantageous to you. Therefore be careful and fully vet this 457(b) opportunity with your accountant, financial planner, and employer benefits department before participating. Additionally, make sure you have all the pertinent information from your employer about how the pre-tax 457(b) plan is set. The non-governmental employer owns the 457(b) account, not you, so you must understand your financial and legal situation here.

An example of Pre-Tax 457(b) Plan Magic at Work

In our case the added element of a 457(b) plan allowed us to do the following:

• Contribute the maximum to a 403(b) (like a 401(k)) for my spouse through my spouse’s employer. For 2024 the maximum 403(b) contribution amount is $23,000.  Further, for individuals age 50 and over the catch-up maximum is $7,500 for a total combination of $30,500.  Again, these contributions are pre-tax retirement accounts.

• Contribute the maximum to a 403(b) (like a 401(k) but for tax-exempt organizations) for me through my employer. For 2024 this amount is $23,000. Additionally, the age 50 and over catch-up maximum is $7,500. This combined total contribution is $30,500 for those age 50 and over.  These contributions are pre-tax thus reducing our taxable income.
• Contribute the maximum to a 457(b) (see above) for non-governmental tax-exempt organizations for certain eligible individuals through my employer. For 2024, the maximum contribution is $23,000. Again, the age 50 and over catch-up maximum only applies to government plans as noted above.  In my case, these contributions were pre-tax.
• Contribute the maximum to a Health Savings Account (HSA) since we have an HSA qualifying high-deductible health plan. For reference, HSA contribution limits for 2024 are $4,150 for self-only coverage and $8,300 for family coverage. Individuals age 55 and older can also contribute an additional $1,000 as a catch-up contribution.  These contributions are pre-tax. Check out the Mad Fientist’s post on why the HSA is the ultimate retirement account.

Magic Trick Upon Magic Trick

Separately and not through our employers my spouse and I also contributed to a Roth IRA at the maximum level.  In 2024, the maximum Roth IRA contribution is $7,000 per person. You can add an extra $1,000 in catch up contributions if you are age 50 and older.  Additionally, the Roth IRA has certain eligibility requirements based on your modified adjusted gross income and your IRS filing status.  Roth IRA contributions are after tax contributions, meaning you pay your taxes first and then contribute to the plan.  The Mad Fientist has a great article on megaback door Roth IRA contributions that is worth checking out.

      So, in our case, participation in the 457(b) plan allowed us to further maximize our retirement investments while reducing our taxable income.  Reducing our taxable income meant that our modified adjusted gross income left no question that we were eligible for the Roth IRA.  Maintaining eligibility for Roth IRA was important to us.  In my opinion, the Roth IRA has many upsides and is a great retirement vehicle.  More on that at another time. 

Through the utilization of the 457(b) and other retirement vehicle noted about we were able to contribute over $70,000 to pre-tax and post-tax, not counting other investments.  Even as I write this, I am struck by how incredibly blessed we are since according to the U.S. Census, median household income was $67,521 in 2020, a decrease of 2.9 percent from the 2019 median of $69,560.  I note this not to boast, but simply to let you know that this is possible.  As soon as we were aware that the 457(b) option existed, we immediately reconfigured our financial situation to maximize this benefit.  I realize not everyone is in the situation. 

Concluding Thoughts

Had the pre-tax 457(b)plan been an option for us earlier, we may have maximized it instead of directing money to after-tax options beyond the Roth IRA.  If you are eligible, participating in a pre-tax 457(b) plan is a great tool to amplify and speed up your ability to reach financial independence (FI). Whatever type of FI you are trying to reach if you are eligible and you can afford it, the 457(b) is another beneficial tool in the toolbox.

Again, I realize the 457(b) plan is a niche option only available to a small group of individuals but I wanted to mention it in case it helps other members of the FI community reach their goals.