As an employed physician, are you tired of seeing half your paycheck go to taxes? Employed physicians face a lack of tax-sheltered savings space compared to their business-owning counterparts.
After you max out your 401k/403b, there are few options for tax-deferred savings. There is an option offered by some hospitals and health systems, the 457(b) plan.
On the surface, the 457(b) plan appears to be just what employed physicians need, more tax-deferred savings space!
An Introduction To The 457(b) For Physicians
The 457(b) plan is an employer-sponsored, tax-deferred deferred compensation plan. The information found online can be very confusing because the same section of Internal Revenue Code covers the 457(b) plan offered to 2 different types of workers:
The first type of 457(b) is provided to state and local government employees. Think teachers, police officers, firefighters, and other civil servants. These are known as governmental 457(b) plans
The second type of 457(b) is offered to high paid (top-hat) employees of nonprofits like hospitals and charities. Think physicians and administrators. These are known as non-governmental 457(b) plans.
Although they have the same name and fall under the same section of the tax code, they have very different rules that apply. If you left a non-profit hospital to work for the VA, you cannot roll a non-governmental(hospital) 457(b) plan into a governmental(VA) 457(b). They are separate programs with the same name.
For example, If you left a non-profit hospital to work for the VA, you cannot roll a non-governmental(hospital) 457(b) plan into a governmental(VA) 457(b). They are separate programs with the same name.
For the rest of this post, I will be referring to non-profit 457(b) plans.
Advantages of the 457(b) Plan
On the surface, the 457(b) looks almost exactly like a 401k. Like your 401k, there are some major benefits to the 457(b):
- Pre-tax contributions are invested in mutual fund or other investments offered by your employer. Because these contributions are pre-tax, they lower your taxable income (adjusted gross income).
- Your earnings and contributions grow tax-free until your retirement or separation from the company.
- The biggest advantage to the 457(b) plan is that unlike the 401k if you leave your job or retire before the age of 59 1/2 you can withdraw your funds without paying the 10% early withdrawal penalty.
- Because the contributions can be made automatically by your employer, it is less painful than making those contributions on your own.
How Much Can You Save?
For the 2016 tax year, you were able to save $18,000 in your 401k and then save an additional $18,000 in your 457(b), doubling your savings! This brings your total pretax savings space up to $36,000, not counting any employer match.
It’s not the $50,000 available to your business owning counterparts but more than enough room for most high-spending physicians.
For bonus points, you can still do a backdoor Roth IRA for an additional $10,000 in retirement savings but without the tax-deferral treatment.
What’s not to like about the 457(b)?
Like most things that sound too good to be true, the same is true for the 457(b) plan.
Negative #1: You Can’t Roll A 457(b) Into Any Other Plans
Unlike your 401k, when you leave your employer you cannot roll your non-governmental 457(b) over into an IRA or another tax-sheltered account.
You either have to take the distributions, keep it where it is or move it into a different non-governmental 457(b) account.
The requirements for distributions at termination are employer specific. Some companies will allow you to keep the balance in their 457(b) after you leave, others require you to take the distribution.
What happens when you leave your job is an item you have to look at on a case by case basis. You will need to speak to the plan manager at your hospital to get the specifics. It is an important decision and not the first question that comes to mind when you first start making your contributions.
If you choose to transfer jobs from a non-profit hospital to a for-profit private group, you can be stuck with the entire balance, potentially hundreds of thousands of dollars you deferred being taxable.
Negative #2: Some 457(b) Plans Are Loaded With Poor Investments
Another item to consider when looking at investing in a 457(b) is the investment options offered to you through the plan. In years past, some governmental/public service 457(b) plans were loaded with annuities and high-cost mutual funds.
The high costs of these funds may eat up most of the tax-deferred growth you were expecting. In these situations, it may be better to pay the taxes now and use low-cost index funds in a taxable account.
The two 457(b) plans I have had experience with had an OK mix of funds. Not the lowest cost but there were some options with expense ratio’s less than 1%. There were very few options in the 0.2% range.
Negative #3: The Insolvency Risk Is A Gamechanger
The 457(b) originates from a different part of the tax code than the 401k. It’s not a retirement saving plan but a deferred compensation plan.
The deferred compensation part means just what it sounds like; you don’t have the money yet! The deferred compensation in your 457(b) plan despite being invested at your discretion, still belongs to the hospital because you have deferred being paid.
If the hospital were to go bankrupt/insolvent, you would have to get in line with the rest of the creditors to access your money.
Here is where it gets tricky when deciding to invest in a 457(b). If you are a young physician starting out with 30 years ahead of you, do you think your hospital/employer will remain solvent for the next 30 years of healthcare reform?
The biggest benefit of the 457(b), the 30 years of tax-deferred compounding is also its biggest weakness.
Many physicians paying attention to the financial underpinnings of healthcare would not take that bet.
It is well publicized that the costs of healthcare continue to rise unsustainably and at some point, the music is going to stop.
If a hospital or health system is in trouble, you will typically see the warning signs well ahead of time. However, even if you see the writing on the wall, there are some negatives to early withdrawal even if you change jobs.
Counterpoint to the Insolvency Risk
457(b) plans are called “top hat” plans for a reason. They are only available to the highest earning employees of the hospital. This tends to be the upper administration and the physicians.
Despite the conflicts between physicians and administration at many facilities, the administration and physicians are in the same boat with regards to the 457(b) plans. If the hospital becomes insolvent, the administration loses their savings as well.
You would hope that the CEO is not going to make choices that will undermine his retirement savings.
Some factors are out of everyone’s control. If you are in a local with a poor payer mix, falling reimbursements and overzealous construction going on, think twice about using that 457(b).
To Contribute to a 457(b) Is No Small Decision
Let’s keep this in perspective. Why are we thinking about using the 457(b) in the first place?
TAXES! How much tax are we talking about? For a physician in the top tax brackets, you are looking at a tax savings of around $5000 per year give or take the specifics of your situation.
If you were to invest that $5,000/year of tax savings in low-cost index funds for 30 years at a 7% return, it would be worth about $472,000 when you retire.
That doesn’t including the future value of the additional $18,000/year you are saving for retirement. The estimated future value of those savings would be worth about $1.7 million.
If you choose to not max out your 457(b) each year, one could argue that you are giving up a potential $2.1 million dollar swing in retirement savings if you spent the $18,000/year.
If you want to run the numbers here is the link I used to calculate these totals.
One Last Problem: What To Do If I Change Jobs?
This topic has become relevant for me because I have started exploring my options for potential geographic arbitrage. As I mentioned earlier, we have fallen into the high costs of being busy but have done a good job of tracking our financial vital signs.
Because we now know exactly where our spending goes each month and track our now falling debt totals, we have reached the conclusion that if we want to see rapid changes in our situation we will have to make big moves if we are to make our goal of repaying our $1,000,000 of debt in ten years or less.
If I Change Jobs, I Will Have Two Options:
- Take the lump sum payment and potentially wipe out 50% of the value of my account due to a huge tax bite.
- Keep it in my old companies 457(b) plan and hope that they stay solvent until I retire.
Neither of these are great options, and the details of your situation will depend on your specific plan so be sure to read through the documents closely.
For the reasons, I decided to stop contributing to my 457(b) plan. I may just the balance in the 457(b) to float our living expenses through the pay drought that occurs when you change jobs and hope that my income loss balances the taxable lump sum distribution.
457(b) Plan Summary:
- You may get significant advantages for participating in a 457b plan:
- Your contributions and earnings in your 457b plan are tax-deferred
- Your account can grow exponentially over time through the power of compounding
- You may be eligible to take the Saver’s Tax Credit for elective contributions to your account
- Unforeseeable emergency withdrawals are available, as long as certain qualifications are met.
- You may withdraw from the account penalty-free before the age of 59 1/2 when leaving your job or retiring.
- Your savings are only as safe as the financial stability of your employer.
- If you leave your job for a new Job in the private sector and take a lump sum distribution before age 59 1/2 you may still lose 50% of the value of your account due to taxes
What Do You Think? Does a 457(b) have enough advantages to outweigh the negatives of the plan?
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