457 vs. Roth IRA? Deciding which type of retirement account is best for you can often be challenging. 457s and Roth IRAs are both great options, but each has advantages and disadvantages. In this guide, we will break down the pros and cons of a 457 plan and a Roth IRA so that you can decide which is better for your financial situation.
457 vs. Roth IRA
| Roth IRA | 457 Plan | |
|---|---|---|
| Owner Type | Individual | Government Employees |
| Wealth Tax | Tax-Free Growth | Tax-Deferred Growth |
| Income Tax | Tax-Free Income | Taxable Income |
| Annual Contribution | $6,500 | $22,500 |
Roth IRA
A Roth IRA is an individual retirement account that allows you to make money without paying taxes. It was named in honor of Delaware Senator William Roth, after whom the term ‘Roth IRA’ was coined for introducing legislation authorizing IRAs on a conditional basis.
Roth IRAs are funded with after-tax income, so there is no upfront tax deduction. But the money can grow tax-free over time, and withdrawal will also be free from taxes.
If you work, you can put your earnings into a retirement account.
Contribution Limits
In 2023, the contribution limit was $6,500 a year. People who are 50 or older can deposit up to $7,500.
Who can not contribute to a Roth IRA?
If you make more than $153,000 a year as an individual or are married and make more than $228,000 a year together, you cannot contribute to a Roth IRA.
You can not contribute to a Roth IRA if you do not receive earned income.
Required Minimum Distributions (RMD)
No minimum distributions (RMD) are required if you invest in a Roth.
How To Open A Roth IRA
A Roth IRA account must be created with a company that the IRS approves. This includes banks, brokerage companies, federally insured credit unions, insurance companies, and savings and loans.
You can open a Roth at any time. But it would be best to do it before the owner’s tax filing deadline, usually April 15th. After that, you cannot get an extension.
What Type Of Money Can Be Contributed
Only earned income can be contributed to a Roth.
W-2 Employees
If you are a W-2 employee, the money you make from your job can pay for a Roth IRA. Things like wages, salaries, commissions, and bonuses can all count.
Self-Employed
If you are self-employed, compensation is the individual’s net earnings from their business, less deduction allowed for contributions made to retirement plans on their behalf, and further reduced by 50% of the individual’s self-employment taxes.
Divorce
Money related to divorce can also be contributed. This is called alimony. Child support or money from a settlement can also be put in the account.
What Type of Money Can Not Be Contributed
- The rent from your rental properties
- Profits from selling a property
- Dividends or interest earned from investments
- Income generated from retirement plans
Spousal Roth IRA
A married partner can fund their spouse’s Roth account. It doesn’t matter what their income is. Spousal Roth IRAs are the same as regular Roth IRAs but must be held separately from each other’s accounts.
Eligibility
- You are married and file taxes jointly.
- The individual making contributions must use earned income.
- Make less than $228,000 as a household.
Distributions
Qualified Distributions
You can take your money from a Roth IRA without taxes or penalties. If you only take out what you put in, the money is not taxable, and there are no penalties. This is known as a qualified distribution.
If you have a Roth account and want to get the money out of it penalty-free when you are older, it must happen at least five years after the first time you put money in. And the money has to come out under one of these conditions:
- Owners are at least 59½ when they take money from their Roth IRA.
- The distributed assets must be used to buy, build, or rebuild a first home. This can only happen for $10,000 per lifetime.
- A person’s Roth IRA can be distributed after they become disabled.
- The beneficiary of a Roth IRA owner’s account will get the money after that person dies.
5-Year Rule
When you withdraw money from your account, it may be taxed. The percentage that it will be taxed depends on how old you are. If you have met the 5-year Rule, there is no tax or penalty when withdrawing your account.
You’ve waited at least five years:
- Younger than 59½: Earnings are taxed and penalized by 10% (Early Withdrawal Penalty). However, you can avoid taxes and penalties if you use the money to buy your first home. You can also avoid taxes if you have a disability or die.
- Age 59½ and older: No taxes. No penalties.
You have not waited for at least 5-years:
- Younger than 59½: Earnings are taxed and penalized by 10% (Early Withdrawal Penalty). However, you can avoid penalties if you use the money to buy your first home. You can also avoid penalties if you have a disability or die or use the withdrawal for qualified education expenses.
- Age 59½ and older: You are paying the taxes but avoiding the penalties.
Non-Qualified Distributions
If you take money from your Roth account too early, you may have to pay tax and a 10% penalty. The exceptions are:
- Unreimbursed medical expenses. It is okay if you use the money to pay for medical bills that are more than 10% of your annual income.
- If someone has lost their job, they might need to pay for their medical insurance.
- The withdrawal is used for qualified higher-education expenses. This includes tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible
- You can get up to $5,000 for your pregnancy or adoption if you withdraw within one year of giving birth or adopting.
Roth Conversion
A Roth IRA conversion allows owners to convert their traditional IRAs into Roth IRA accounts. This allows investors to:
- Pay the taxes on their tax-deferred savings and earn interest tax-free.
- In addition, they receive tax-free income when they retire.
- Withdraw their contributions at any time, tax-free.
- Finally, avoid required minimum distributions (RMD) in the future.
457 Plan
A 457 plan is offered to state, local governments, and top-level nonprofit employees. There are two types of these tax-advantaged retirement plans:
- 457(b) for state and local government employees
- 457(f) for C-level executives of nonprofits.
457(b)
For a 457(b) plan, you can contribute up to $20,500 in 2022 and 22,500 in 2023. You may contribute an additional $7,500 in 2023 if you’re 50 or older.
Source: Internal Revenue Service
457(f)
The 457(f) plan differs from the 457(b) plan. They are tied to how long you work and other performance-based metrics.
- They are primarily used to recruit executives from the private sector.
- The compensation plan is deferred from taxation.
- The deferred compensation must be subject to a “substantial risk of forfeiture,” which means the executive risks losing the benefit if they fail to meet the service duration or performance requirements.
- Once the 457(f) plan becomes guaranteed and no longer subject to the risk of forfeiture, it becomes taxable as gross income.
Deferred compensation is not paid to the executive and sheltered from taxation until the services have been performed for at least two consecutive years.
Amounts deferred are subject to the risk of forfeiture, but there’s no limit on how much income can be deferred.
457 Plan Pros
- You can pay an extra $7,500 annually if you’re at least 50 years old.
- Unlike other retirement plans, your 457(b) benefits become available to you without penalties when you no longer work for the employer, even if you are younger than 59½ years old.
- When you leave your job, you can roll over your account into an IRA, 401k, or IRA annuity. This option is only for the 457(b) plan, not the 457(f) plan.
457 Plan Cons
- Employer contributions count as part of your annual maximum contribution.
- Limited governments provide matching programs within the 457(b) plan. Employees have the responsibility to save enough to meet their own needs.
The 457(f) requires that employees work for two years before being eligible for this plan. If the executive leaves the company before their time ends, they forfeit any rights to the 457(f) plan.
How to spend a Roth IRA efficiently in retirement
Once the Roth IRA requirements are met, an owner can transfer their account into a Roth annuity with a lifetime income rider. The annuity will then distribute a tax-free income for the rest of the retiree’s or married retirees’ lifetimes, even after the Roth IRA has run out of money.
Younger investors can contribute to a new Roth IRA annuity or convert their traditional IRAs into a Roth IRA annuity and guarantee their future tax-free income during retirement.
How to spend a 457 plan efficiently in retirement
Employees can’t touch their 457 plans until they’ve left their employer. At that time, a 457 plan owner can roll over their retirement savings plans into a deferred IRA annuity with a lifetime income rider without tax consequences. The annuity will then equally distribute (now or in the future) a percentage of the retirement account for the rest of the retiree’s or married retirees’ lifetimes, even after the account has run out of money.
What Do My Beneficiaries Receive When I Die?
A Roth IRA and 457 plan will provide a straightforward death benefit, the retirement plan’s account value in a lump sum.
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Frequently Asked Questions
How much can I put in a roth ira?
For 2022, the contribution limit for a Roth IRA is $6,000 per year. If you are 50 years or older, you can contribute an additional $1,000 as a catch-up contribution, making the total $7,000. Eligibility to contribute to a Roth IRA phases out at certain income levels. Always check current IRS guidelines for updates.