Planning for Physicians: Managing Contributions Between a 401(k), 457(b)

As many of our readers likely know, the Federal government provides strong incentives for saving for retirement and other financial goals. You can break these down into three broad categories: tax deductibility (on contributions), tax-free distributions (i.e. withdrawals), and tax deferral (on growth). Many physicians can increase their tax deductions and benefit from tax deferral by contributing to both a 401(k) plan and a 457(b) plan.

401(k) and 457(b) plans are both employer-sponsored retirement plans. The main difference is 457(b) plans can only be sponsored by certain entities, namely state and local governments, along with nonprofits such as hospitals, charities, and unions.

In most cases, contributions to employer-sponsored retirement programs are aggregated. That means if you work for two different employers with two separate 401(k) plans, you can only contribute a maximum of $19,500 (in 2021, under age 50) between both plans. A 457(b) plan has a similar contribution limit of $19,500 (in 2021, under age 50), but 457(b) plan contributions are counted separately from other plans. Due to the regulatory framework, 457(b) plans are particularly common among nonprofit hospitals and are often run side by side with 401(k) plans. So if you’re employed by one of the two major hospital systems in the Fargo-Moorhead area, I can assure you as of the time of this writing, both are running these plans side by side. 

But what does this all mean? 

To be blunt, it means you have the opportunity for a very large tax deduction. You can max out both a 401(k) plan and a 457(b) plan for a $39,000 deduction (50 and under) or potentially a $45,500 deduction (50 and over). This can be an excellent vehicle if your taxable income will be lower in retirement than it is now. 

Okay, what’s the catch? 

Detailed financial planning is a must due to some of the pitfalls with these plans. Oftentimes, the account must be withdrawn over a period certain. That means you may have to draw down the account over a certain term of years. For example, your 457(b) may have to be withdrawn over a period of 10 years. If you have a large retirement account with required minimum distributions (RMDs) starting at age 72 and you’re retiring at age 65, it necessitates some detailed planning so you don’t unnecessarily increase your taxable income when RMDs start. We have also run across estate planning issues with certain plan rules, such as cashing out entire accounts when a participant passes away. It is very important you are aware of the pitfalls of these plans before funding your account. 

What now?

Set a meeting with your advisory team to weigh the pros and cons. Your financial planner, accountant, and/or attorney will be able to walk you through what is best for your goals. Neither Heartland Trust Company nor I provide tax advice. Consult with your tax professional before making any decision regarding the material discussed in this article.