There’s not a perfect financial planning vehicle in existence. Salary deferral plans, like many retirement plans and 457 plans, carry pros and cons. Many hospital systems have a combination of 401(k), 403(b), and 457 plans. The 401(k) is often designed for the employees who make under a certain amount, say less than $150,000 or so. Then the 403(b) with an option to contribute to a 457 salary deferral plan is available for the employees making above that income threshold. This structure seems complicated, but it allows the additional salary deferral for the highly compensated, and it keeps the hospital compliant with ERISA regulations. A 457 plan is also only allowed for certain types of governmental or nonprofit organizations, and that’s why it’s always paired with a 403(b).
What is a 457 plan? First, let’s discuss what a 457 plan isn’t. A 457 deferred compensation plan is not a retirement plan. It looks like a retirement plan because a portion of salary can be tax-deferred – or a part of income can be redirected to the account, and that portion of income is not included in taxable income. For example, if a physician makes $200,000 and defers $19,500 (the current maximum allowed) into a 457 plan, then the physician will owe taxes on $180,500. That $19,500 can then be invested, and there’s no capital gains tax due on the investment growth for the entirety of the plan. When funds from the plan are withdrawn, income tax is due. A retirement plan, such as a 401(k) or a 403(b), works the exact same way, so why isn’t a 457 plan a retirement plan? With a retirement plan, there are penalties for early withdrawal. Unless a special circumstance occurs, there’s a 10% penalty on withdrawals from retirement accounts before age 59 1/2. In contrast, a 457 plan isn’t designed to fund retirement. Instead, a 457 plan is intended to defer salary to some unspecified future date or until age 72 (like retirement plans, there’s a 50% penalty if a minimum amount is not withdrawn each year beginning at age 72). Without a 10% early withdrawal penalty, there are so many more uses for this kind of plan! It can double as an emergency savings account if something really devastating happens, it can be used to pay for a child’s college experience, or it can be deferred until retirement. A 457 plan can even be rolled into an IRA and donated to charity (this could potentially give the donor a tax break and help a nonprofit company raise funds, but that’s another can of worms we won’t open right now).
So yes, a 457 plan can be rolled into an IRA when a physician leaves an employer or is required to take an RMD (required minimum distribution). If a 457 plan is rolled into an IRA, it becomes a retirement account, and it is no longer the salary deferral plan it used to be. So why in the world would anyone roll a 457 plan into an IRA? Here’s something to understand about 457 plans. The assets of a 457 plan are subject to the employer’s creditors in the event of a bankruptcy. On the other hand, retirement plan assets are held separately in a trust, and they are not considered assets of the employer, so they are protected against a hospital system’s bankruptcy. If a hospital goes bankrupt, the retirement plans would remain intact, but the 457 plans could be liquidated to pay off the hospital’s bad debts. This is a major consideration in the time of COVID-19 since the shutdown of elective procedures, falling revenues, and increasing costs with PPE and COVID-19 compliance and surveillance has crippled hospitals financially. Some hospitals even require a rollover of 457 plan assets upon separation of service for that very reason. It’s bad news when a major employer fails; it’s even worse when the employer takes the employees’ money to pay for a bankruptcy. For a major hospital system, even if it’s a scary proposition that 457 plan assets are subject to creditors, it’s generally not a likely circumstance; however, 2020 has not been kind to the health care sector. If 2021 and 2022 don’t provide relief, it very well could alter the conversation.
Another difference of a 457 when compared to a retirement plan, such as a 401(k) or 403(b), is that an employer is not allowed to fund a 457 plan. There are often matching provisions in a retirement plan that allow the employer to fund the retirement plan if the employee also contributes. The employer can even elect to fund a retirement plan, whether or not the employee funds the plan. In a 457 salary deferral plan, this is not the case. Matching or funding from an employer is not allowed. The purpose of the 457 plan is to defer the employee’s salary, so the employer technically cannot get involved in the funding or deferring of the employee’s salary.
For many physicians, deferring income can make a lot of sense. Income earners in the top tax bracket get hit with some extra taxes, such as the Medicare surtax on investment income, the ACA Medicare additional tax, and an extra 5% in long-term capital gains tax, to name a few. Tax deferral plans are an easy way to plan for current income taxes. I recommend funding the 457 plan to some physicians and not others. Income isn’t the difference-maker in funding a 457 plan; rather, it’s the planning fundamentals, such as estate planning and liquidity (less important with a 457 plan since there’s no early withdrawal penalty) insurance, and lifestyle considerations. In all of life, proper balance is necessary for nature to thrive. Financial planning doesn’t deviate from requiring balance to thrive. If there is not a balance of saving and spending, the plan can be subject to stress and possibly failure. When some of the more concerning and pressing details of a financial plan are complete, depending on the goals of the physician, a 457 plan can be a nice layer of tax-deferred savings.
Paul Morton is an investment advisor, Midwest Private Client Group.
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