Welcome back to the Deep Dive. Today, we're going
to step away from the usual, you know, the corporate
world of the 401k. Right. And we're diving straight
into the retirement plans that are really the
backbone for public service. We're talking about
the financial engine that supports our teachers,
our city workers, hospital staff, nonprofit employees.
The often I think. Very misunderstood 403b and
457 plans. That's absolutely right. I think for
a lot of people, especially if you're new to
the public sector or the nonprofit world, you
just look at these plans and think, OK, it's
just a substitute for a 401k. A different name
for the same thing. Exactly. But as we unpack
the detailed source material you've shared, we
find they're not just structurally unique. They
have some really surprising flexibilities and
crucially, some very specific financial and legal
risks. And those risks are tied to. directly
to who your employer is, which is a scary thought.
It is. So our mission today for you, the listener,
is to give you the definitive checklist, but
fast. We want to demystify these plans, lay out
all the critical compliance quirks and really
highlight the advantages. And the disadvantages.
And the severe disadvantages. We're looking at
regulatory documents, IRS guidance, legislative
history, all to get to the core of how these
plans really work. And, you know. If we start
at that 30 ,000 foot view, the high level comparison,
you do see a common ground. Okay. Both the 403B
and the 457, they run on employee salary deferrals.
You put money in pre -tax, it goes tax deferred,
and then you pull it out. The core engine of
retirement savings. That's the one. And when
you do finally take distributions in retirement,
that money is typically taxed as ordinary income,
just like a traditional IRA or 401k. And both
plans also have that same rule for when you have
to start taking money out, right? The RMDs. Yep.
Thanks to some rule changes back in 2020, both
plans are subject to required minimum. distributions
or RMDs starting at age 72. So that's the common
ground. But that's pretty much where it ends.
The divergence in who can have them and how they're
billed, it's immediate and it's critical to understand.
It really is. The 403B, for instance, that's
specifically for public education organizations,
501c3 nonprofits, cooperative hospitals, and
even self -employed ministers. Very specific
slice of the workforce. Very. And its tax treatment
used to be... Well, less flexible than a 401k.
But that all changed after EGTRA. The Economic
Growth and Tax Relief Reconciliation Act of 2001.
That's the one. That act really brought the 403b's
rules much more in line with the 401k structure
we all know. And then there's the 457, which
you sometimes see offered right alongside a 403b
for public employees. But it's a different animal.
A completely different animal. The 457 is what's
called a non -qualified deferred compensation
plan. It's for governmental employers. State
and local agencies, cities, public universities.
Isn't the important part. And certain specific
non -governmental employers. And that distinction,
governmental versus non -governmental. That's
the pivot point for our entire discussion today.
Because that one word changes everything about
the security and the risk you're taking on. Everything.
OK, let's unpack the 403B first. Let's see why
its life is so different. Absolutely. Let's start
with the 403B. You know, when people talk about
this plan, you still hear its old name all the
time. The tax sheltered annuity. The TSA. That
name, that TSA moniker, it tells you everything
about where this plan came from. Historically,
the plan was restricted to just annuity investments,
a fixed stream of payments. But that's not true
anymore, is it? Not for decades. One of the surprising
things our sources make clear is that since 1974,
participants have been able to invest in mutual
funds, too. But the name stuck. The name stuck.
And I think that habit of calling it a TSA, of
seeing it just through that insurance product
lens, it still persists. So to be clear on eligibility,
we're talking public education, 501c3s, hospitals,
ministers. It's fundamentally built for a service
-oriented workforce. And that's what leads to
the single biggest structural difference between
a 403b and a 401k. And that's the ERISA question.
ERISA, the Employee Retirement Income Security
Act of 1974. The big federal law meant to protect
our retirement savings. Exactly. But here's the
key. 403B plans are not required to be what's
called technically qualified plans under the
tax code or governed by ERISA. Hold on. How can
a major retirement plan not be governed by the
main law designed to protect retirement plans?
That sounds like a huge security risk for the
employee. It sounds totally counterintuitive,
right? But for the employer, especially a small
nonprofit or a public school, it's a massive
administrative gift. How so? If the 403B is not
an ERISA plan, which is... pretty common if the
employer isn't making contributions. It gets
to sidestep a lot of the really expensive technical
hassles of a 401k. Like what? What's the biggest
one? The biggest relief is getting rid of the
complex non -discrimination testing for salary
deferrals. All right. So with 401ks, they have
to run these intricate annual tests to prove
the plan isn't just favoring the high earners.
It's a huge headache for HR. A massive burden.
So instead of all that complex testing, 403bs
have something called the Universal Availability
Standard. And what does that mean? It's much
simpler. It just means that generally all employees
have to be allowed to make salary deferral contributions
as long as they meet some basic age and service
rules. It's about broad access, not complex proportional
testing. And that's simplicity. must save these
organizations a ton of money and time. It absolutely
does. That's why the 403B is so popular in these
sectors. Non -ARISA 403Bs have way simpler and
cheaper annual reporting. They file a simpler
version of the IRS Form 5500. And the big one.
And the big one. They get to avoid the super
expensive, time -consuming, independent auditor
requirement that applies to most big 401ks with
over 100 participants. That reduction in compliance
burden, it's often the deciding factor. factor.
Okay, let's pivot to the employee side. Let's
talk about getting your money out. Like a 401k,
the money is supposed to be for retirement, so
it's locked up for a while. That's right. If
you're under age 59 and a half, you generally
can't take an early withdrawal, not unless a
specific triggering event happens. And those
events are things like... Our sources always
list the same ones. A proven financial hardship,
a disability, or leaving your job separation
from service. That's the firewall to keep the
money in there. But if one of those things does
happen and you need the money... you're going
to get hit with a pretty painful tax consequence.
That's the mandatory discouragement built right
into the system. If you take an early withdrawal,
first, the whole amount is taxed as ordinary
income. And then on top of that, the IRS hits
you with a mandatory 10 % federal tax penalty.
It ensures that even if you're taking it out
for a hardship, there's a steep price to pay.
And, you know, before we move on from this, I
want to touch on a compliance detail that I thought
was fascinating. The written plan requirement.
It sounds like the IRS had to step in and force
some organization on these plans. Yes, this is
a great look into how regulations evolve. Historically,
a lot of these plans were super decentralized.
You'd have an organization with multiple vendor
contracts and no single unifying document. Chaos.
Total chaos. So the IRS finally said enough.
They mandated that all plans must have a formal
written plan document. On December 9, 2008, they
gave sponsors a one -year reprise to get it done.
Why give them a year? Well, it was an acknowledgement
of just how messy it was. They knew it would
be impossible for everyone to formalize decades
of informal agreements overnight. But... And
the sources stress this. Even with the reprieve
on the paperwork, the plan still had to operate
in compliance with all the rules. It was the
government basically saying it's time to professionalize
this system. Exactly. It had just gotten too
loose. That's a great summary. Now let's get
into how the legal security of the 403B has fundamentally
changed for the better. This is where it gets
really interesting for me. The whole bankruptcy
barrier before 2005. This is so important because
it explains why not having a RESA status used
to be this point of extreme vulnerability for
employees. So what was the rule before 2005?
Before the Bankruptcy Abuse Prevention and Consumer
Protection Act, or BAPCPA, a non -RESA 403B was
generally not protected property. It wasn't something
a debtor could claim as exempt. So if a teacher
in a non -RESA plan declared bankruptcy, they
could literally lose... lose their entire retirement
savings to creditors. That's terrifying. It was
a massive risk and the legal landscape was a
total mess. The safety of your savings depended
entirely on the nitty gritty details of how your
employer set up the plan. The Henry Barnes case
from 2001 just highlights this confusion perfectly.
Okay, walk us through that case. It sounds like
a perfect example. In Barnes, the person had
a 403B account. The judge ruled that the money
invested in a fixed income annuity could be seized
by creditors. Why? Because it lacked the specific
trust language and anti -alienation clauses needed
for protection. But, get this, the variable account
within the same plan was ruled to be protected
under a different part of the code. So depending
on which subaccount your money was in, you could
lose it all. Precisely. It was a lottery. Back
then, having that Arisa anti -alienation clause
was the gold standard. It gave your assets the
same kind of protection as a spendthrift trust,
making them untouchable by creditors. This gap
created a really unfair situation. And Congress
finally stepped in with BAPCPA in 2005 to fix
it. Yes. That 2005 reform was a landmark. It
extended federal bankruptcy protection to 403Bs,
to IRAs, to other retirement plans, shielding
them from creditors. Regardless of whether they
were arrests or not. Exactly. It closed a huge
security gap for public servants. It was a massive
win for financial security in the nonprofit and
education world. That's incredibly reassuring.
So today, you can pretty much assume year 403b
has federal bankruptcy protection. Now let's
talk about a more modern feature that really
boosted its appeal. the Roth revolution. The
Roth option completely changed the tax planning
game. Starting in 2006, 403b plans, just like
401ks, could add designated Roth accounts. For
anyone who might be less familiar, just explain
that fundamental trade -off, traditional versus
Roth. Sure. With a traditional pre -tax contribution,
you get your tax break today. You pay less tax
now, but you pay ordinary income tax on everything
when you withdraw it later. Roth is the opposite.
You contribute with after -tax money, so you
pay the tax today. But the huge benefit is that
later on, withdrawals of both your contributions
and all the earnings are 100 % tax -free. That
must be a huge planning tool for people, especially
if they think their tax bracket will be higher
in retirement. It's a game changer, as long as
you meet the two big rules. Which are? The money
has to have been in the plan for at least five
taxable years, the five -year rule, and you have
to be at least 59 and a half. If you check those
boxes, you have a guaranteed tax -free income
stream in retirement. Fantastic. Okay, one last
niche case for this section. Church plans. They
seem to operate in their own little world. They
really do. A church plan is defined as a retirement
plan set up by a tax -exempt church or an association
of churches for its employees. They exist outside
the standard rulebook. So what's their status
when it comes to ERISA? They are specifically
not subject to ERISA and they stay that way unless
the organization makes a voluntary and importantly
irrevocable election to be covered by it. And
because they're outside ERISA, what does that
mean practically? It means they avoid a ton of
administrative work. They don't have to file
the big annual IRS form 5500. They don't have
to distribute all those summary reports and plan
descriptions to participants. And a financial
break, too. A big one. If they have a defined
benefit plan, they aren't required to pay termination
insurance to the Pension Benefit Guarantee Corporation.
It's a profoundly streamlined world that reflects
their unique status. OK, that gives us a really
comprehensive picture of the 403B. Let's shift
gears completely now and talk about the 457.
plan. This one operates with a totally different
philosophy, especially when it comes to getting
your money. Right. If the 403b is for nonprofits
and schools, the 457, this non -qualified deferred
comp plan, is generally the tool for governmental
employers, state agencies, cities, towns. And
there's an interesting group of people who can
participate in a 457 that might not be able to
in a 401k. Yes, this is a neat structural difference.
Unlike 401ks and 403bs, a 457 457 plan, both
the governmental and the non -governmental kind,
can allow independent contractors to participate.
That's a nice little perk for governments that
use a lot of contractors. It is. But the single
most attractive feature, the real aha moment
for employees, is the withdrawal flexibility.
This is what makes the governmental 457 so unique.
This is the big one. This is the big one. A governmental
457 plan has no 10 % penalty for withdrawal before
the age of 55. Which is just a radical difference
from every other. other retirement plan out there
which mostly use that 59 and a half rule. Why?
Why does this one plan get this massive loophole?
It really goes back to its history. It was defined
from the start as a non -qualified deferred compensation
plan, not a fully qualified retirement trust
like a 401k. Because it was built differently.
It inherited this massive flexibility benefit.
It was designed to let government employees defer
income without all the qualified plan rules.
And this came along with it. So just to be crystal
clear. If a city employee leaves their job at
age 52, they can start taking money from their
457 right away without that 10 % penalty. Exactly.
Which makes the governmental 457 an incredible
tool for planning an early retirement. It's often
called a bridge strategy. A bridge to what? A
bridge to age 59 and a half. You use your 457
funds penalty -free to live on until your 401k
or 403b money becomes accessible without penalty.
Now, what's the catch? Because there's always
a catch. You avoid the penalty, but you don't
avoid all the taxes. That's the critical balance.
The 10 % penalty is waived, yes, but the entire
withdrawal is still subject to ordinary income
tax. So you're paying tax, but you're avoiding
that punitive extra tax. Which makes it a much,
much better deal for an early withdrawal. And
just like the 403b, the 457 also got the Roth
treatment. It did just a little bit later. The
Small Business Jobs Act of 2010 allowed 457B
plans to add Roth accounts starting January 1st,
2011. The mechanics are identical. Pay tax now
for tax -free growth and withdrawals later. Okay,
now we get to the power section. This is where
the governmental 457 really separates itself
and lets public servants save at a rate that
most corporate employees can only dream of. We're
talking about stacking and catch -up provisions.
And this all comes down to one single piece of
legislation. EGTRA back in 2001. If you remember
nothing else, remember how EGTRA completely changed
the game for the governmental 457. Before EGTRA,
there was a major limit, wasn't there? A huge
constraint. Before then, if you were lucky enough
to have access to both a 457 plan and a 401k
or 403b, which is common at big public universities,
for instance, your contribution limits had to
be coordinated. Meaning you had one maximum amount
and you had to split it between the two accounts.
You couldn't max out both. That's right. You
were stuck with one single maximum deferral.
It really limited how much people could save.
But EGTRA 2001 came along and got rid of that
coordination limit, but only for governmental
457 plans. created the famous double dip. That
is the pivotal insight. After that, a government
employee could contribute the maximum elective
deferral to their 401k or 403b and a completely
separate maximum amount into their governmental
457. So using the 2021 limits from our sources,
that would mean $19 ,500 into your 403b and then
another $19 ,500 into your 457. A total of $39
,000 in pre -tax deferrals, you instantly double
your savings capacity. That is an incredible
amount of financial leverage. It truly is. Now,
there's one little... nuance your 401k and 403b
limits are still coordinated with each other
you can't max out both of those right the 457
is the distinct account that you get to stack
on top and now we get to layer the catch -up
provisions on top of this and the 457 world has
two very different types of catch -ups let's
start with the first one Type 1 is the one we're
all familiar with. It's the age 50 catch -up,
an extra amount, $6 ,500 in the 2021 example.
That's similar to a 401k. But the key here is
that this is only available under governmental
457 plans. So if you're over 50 and you work
for the state, you can put that age 50 catch
-up into both your 403b and your governmental
457. No, you can use an age 50 catch -up in your
403b and another one in your 457. It's fantastic.
But then you have catch -up type 2. The complex
one. The complex one. This is available in both
governmental and non -governmental plans, and
it's for employees who are within three years
of their normal retirement age. And how is this
one different? It's designed to be a massive
final push. The potential contribution is equal
to the full employee deferral limit. So another
$19 ,500 using those 2021 figures. But there's
a big string attached. It depends on your history.
A huge string. This cash up is strictly limited
to your unused deferral limits from previous
years. So if you've been maxing out your 457
every single year you've worked there. You can't
use this feature. It's gone. It's designed. for
people who were late savers or who couldn't afford
to max out earlier in their career. It's one
last chance to catch up in a big way. That is
a powerful tool for late career savers. So let's
put it all together. Let's talk about the maximum
theoretical potential here. Right. So imagine
you're over 50. You're within three years of
retirement. You have access to both plans and
you have that unused deferral capacity in your
457. You can layer everything on top of each
other. Everything. So on the 401k or 403b side.
You have your elective maximum, $19 ,500, plus
your age 50 catch -up, another $6 ,500. So that's
$26 ,000 right there. Okay, $26 ,000 on one side.
Now, on the 457 side, you get your standard elective
maximum of $19 ,500, plus the full potential
of that type 2 catch -up, which is another $19
,500. So that's $39 ,000 on the 457 side. Exactly.
Add the $26 ,000 from the 401k, and you're at
a potential deferral of $65 ,000. thousand dollars
in a single year sixty five thousand dollars
it's just it's a completely different level of
savings it transforms your retirement runway
it's a level of financial leverage that's pretty
much uniquely available to certain government
employees an unmatched tool a powerhouse okay
now we need to pump the brakes we've just praised
the governmental 457 but now we get to what i
think is the most critical part of this entire
deep dive the great divide the great divide this
is where we separate the golden rules of the
governmental plan from the severe restrictions
and frankly, the massive risks of the non -governmental
457. This is the major caution point for you,
the listener. And it's fascinating how the entire
regulatory structure treats risk and security
based on one thing, your employer's tax status.
Let's start with the governmental 457 again,
the flexible one. In terms of moving your money
around, how portable is it? Extremely. Governmental
457s are generally treated like other qualified
plans for mobility. You can roll them into 401K,
403Bs, and IRAs with very few restrictions once
you leave your job. And why is that so important
for an employee? Because it lets you consolidate
your savings later in life. It lets you take
advantage of better investment options in an
IRA. It means the money is truly yours and it
can follow you. It's secure. It's portable. It's
protected. Okay. Now for the dark side. The non
-governmental 457 plan. These are the ones offered
by large non -profits, some hospital groups.
This is where you need to see the big red flashing
warning sign. The first restriction is the rollover
limitation. It's severe. What is it? Money in
a non -governmental 457 plan can only be rolled
into another non -governmental 457 plan. You
cannot, under any circumstances, roll it to a
401k, a 403b, or an IRA. So your money is captive.
If you leave that job and go to a regular corporation,
those savings are just... They are stuck. But
that's not even the biggest risk. The biggest
risk is asset protection. Or rather, the complete
lack of it. What do you mean? Funds in a non
-governmental 457 plan are not set aside in a
trust for the exclusive benefit of the employee.
Hold on. I, as an employee... defer my salary.
I take home less money in my paycheck. Yeah.
But that money doesn't legally belong to me.
Not in the way you think. The Internal Revenue
Code requires that money to remain the legal
property of the employer. It's a liability on
their balance sheet, like any other debt they
owe. Why on earth would it be structured that
way? It puts all the risk on the employee. Because
that's the only thing that makes the tax deferral
work. If the funds were put in a separate account
just for you, the IRS would say you've constructively
received them and you'd have to pay tax on the
whole amount immediately. The tax deferral only
works because the money is still technically
the employer's. Which brings up the existential
question. Yeah. What happens if my nonprofit
employer goes bankrupt? This is the moment the
risk becomes real. Those funds are available
to the employer's general creditors. You, the
employee with your life savings in that plan,
are just another unsecured junior creditor. You
could lose everything. You could lose everything.
So the governmental 457 is secure and portable.
The non -governmental 457 is basically a high
-stakes unsecured IOU from your employer. That's
the perfect way to put it. Its value depends
entirely on the long -term financial health of
your employer. It is nothing like the ironclad
protection of a 401k or 403b trust. Now, let's
talk about the specific type of this plan, the
457b. It gets a nickname right, a top hat plan.
Who is this high -risk vehicle for? This is where
Arisa actually comes back into the picture, but
in a restrictive way. Arisa says these non -governmental
457B plans must be limited to a select group
of more highly compensated employees. So this
isn't for everyone, like a 403B? Not at all.
It's exclusively for executives or key people.
The sources suggest that the compensation limits
used for 401K testing, you know, in the low six
figures, would probably be an acceptable standard.
Hence the nickname Top Hat. It's for the top
brass. Exactly. The thinking is that executives
are in a better position to understand the heightened
risk and to assess their organization's financial
health. Okay, let's move to the most complex
and maybe the riskiest version of all, the 457F
structure. This sounds like financial engineering
at its most extreme. The 457F plan exists because
these nonprofits are limited in what they can
offer. This is their alternative, a way to attract
and retain top talent with big compensation packages.
What's the main appeal for the executive who
would use a 457F? Two things. First, it's tax
deferred. And second, and this is crucial, it
can exceed the normal annual contribution limits.
It's for those highly paid executives who have
already maxed out everything else. So if an employer
is deferring a huge amount of money way over
the limit, what's the mechanism that makes the
tax deferral legal? It's a heavy -handed mechanism
called the Substantial Risk of Forfeiture, the
SRF. This is the central high -stakes gamble
of the whole plan. Okay, what does Substantial
Risk of Forfeiture mean in plain English? It
means you have to face a real possibility of
losing all the money. The IRS says this requires
two things. First... The money has to remain
available to the organization's creditors. Same
old solve and see risk. Same old risk. And second,
it must be subject to a strict vesting schedule.
So you have to stay with the company for a certain
number of years or you lose it all. Absolutely.
If you leave before you're fully vested, the
money is forfeited. It goes back to the organization.
It's the ultimate golden handcuffs. That's a
brutal mechanism. So what happens when you finally
do vest after, say, five or seven years? This
is the really dramatic part. The second that
risk of forfeiture is gone, the moment you vest,
the entire value of everything that's been deferred
is immediately included in your ordinary income
for that year. The whole pile of money becomes
taxable at once. All at once. The tax deferral
just stops. It can create a massive sudden spike
in your income and it demands incredibly careful
tax planning to handle it. So how do organizations
give the employee some security? to make sure
the employer doesn't just change its mind while
still meeting that IRS risk requirement. They
use something called a rabbi trust. It's a structure
where the deferred money is put into a trust
overseen by a third -party trustee. It feels
safer because the money is physically set aside.
But there has to be a catch, right, to maintain
that risk. There is. To avoid immediate taxation,
the funds in that rabbi trust must remain available
to the employer's general creditors in case of
bankruptcy. So the rabbi trust protects you from
your employer changing their mind, but it offers
zero protection if the employer goes under. That
is the perfect summary. It's security against
corporate whim, not corporate failure. You're
still an unsecured creditor. And finally, we
have to look at the legislative context here,
Section 409A. This came directly out of some
of the biggest corporate scandals we've ever
seen. Section 409A was passed in 2004, and it
was a direct reaction to the kind of executive
behavior we saw at places like Enron and WorldCom.
What exactly were the executives at Enron doing
that Congress wanted to stop? Well, their bonus
plans had these trigger clauses. These clauses
allowed key executives to get immediate early
access to all their deferred compensation if
the company's financials started to look shaky.
So they could cash out right before the company
collapsed, leaving everyone else with nothing.
A textbook case of self -dealing. They could
pull their millions out and leave the creditors
and regular employees holding an empty bag. Section
409A put a stop to that by creating strict rules
about when deferred comp can be paid out. It
prevents executives from using these plans as
an emergency escape hatch from a sinking ship.
Exactly. And that context is so important for
understanding why these plans have such specific
and sometimes harsh rules today. It's a constant
balancing act. Okay, let's bring this all home.
Let's summarize the key takeaways for you, the
listener, after this deep dive into the world
beyond the 401k. First, the 403b. It's for nonprofits
and schools. Its big advantage is administrative
simplicity, thanks to that non -ERISA status
and the universal availability rule. Structurally,
it's very safe, like a 401k, especially after
it got federal bankruptcy protection in 2005.
Second, the governmental 457 plan. This is your
strategic powerhouse. It has two huge advantages,
that unique pre -55 penalty -free withdrawal
option and the ability to double dip on deferral
limits, letting you save massive amounts of money,
maybe over $65 ,000 a year as you near retirement.
Third, and this is the big warning, be intensely
wary of non -governmental 457 plans, the top
hat plans. They are an unsecured liability. The
funds legally belong to your employer. Your savings
are captive and they are totally subject to your
employer's long -term solvency. It is a financial
IOU. And fourth, the 457 plans. They are the
ultimate high wire act. They use that substantial
risk of forfeiture tied to a vesting schedule
to defer taxes. And when you vest, you pay tax
on the entire amount all at once. Even with a
rabbi trust, the money is never safe from the
employer's creditors. This whole journey just
shows how profoundly the legal context, ERISA,
bankruptcy reform, EGTRA, has shaped these plans.
The legal classification literally dictates whether
your retirement savings are a secure asset or
just an unsecured promise. So as we close, let's
leave you with this final provocative thought
to consider. We saw how the 2005 bankruptcy reform
closed the security gap for the 403B, making
it safe. But given that these non -governmental
plans fundamentally rely on your employer not
going bankrupt with the funds technically remaining
their property, what is the true long -term cost
of that tax deferral? And how might a future
law change the game again, maybe alter investing
rules or even requiring some asset protection?
It's something to ponder as you look at your
own retirement options and the financial health
of the entity that signs your paycheck. A fascinating
and critical part of financial planning that
really demands your attention. Thank you for
joining us for this deep dive. We hope you feel
thoroughly informed and maybe a little more prepared
to assess the true risk in your own retirement
portfolio.