Should physicians use 457(b) as a tax saving vehicle?

Author Randy Thurman once said: "A penny saved is worth two pennies earned.......after taxes."

If we take this sentiment seriously, it is imperative that we save as much as we can since taxes are here to stay. Having said that, physicians are a little different when it comes to the saving strategy. The good news is that physicians usually are high earners so they have better chances of saving. The bad news is that physicians usually are high earners so they will be paying more taxes due to higher tax bracket which can reduce their saving ability, especially with huge amount of student loans they have gathered by the time they start working.

Over the last two decades, more physicians are becoming employed with a standalone hospital or large health systems. This trend is likely to accelerate and not reverse any time soon. Employed physicians have limited choices when it comes to tax saving vehicles and retirement accounts compared to their self-employed or contracted counterparts. Some of these vehicles include 401(k), 403(b), traditional IRA, HSA and 457(b).

While much has been written about the first four types of tax saving vehicles listed above, a decent percentage of physicians find themselves lacking knowledge about another good option  - 457(b). Many physicians who are employed by a government or a non-profit organization, have this option available to them but may not have explored it much. Today, we are going to touch upon this option which hopefully will motivate the fellow physicians to explore it in greater detail.

Is the 457(b) plan is right for me?

In general, just like 403(b) plan is available to the high earners like physicians, 457(b) is also similar in that regards. Both 403(b) and 457(b) having similar annual contribution limits with pre-tax money, providing a great tax saving. The earnings grow tax free and upon distribution, both are taxed as ordinary income. Usually but not always, investment options and fees are similar and both require withdrawal starting at age 70 ½ with required minimum distributions. However, there is one important difference. While there is a 10% penalty for withdrawing money before age 59 ½ with 403(b), there is no such penalty with 457(b). This means that physicians who are planning to retire early can start withdrawing from 457(b) without any penalty.  This makes 457(b) an attractive option.

Types of 457(b)

457(b) plan can be governmental or non-governmental. It is extremely crucial to understand the differences between these two types before making a decision to use it for contributing and tax saving. Governmental 457(b) plan may be offered to physicians who are employed by state university hospitals. Non-governmental 457(b) plan may be offered to physicians who are employed by a non-profit organization. If you are being offered a governmental 457(b) plan, then it makes perfect sense for you to contribute to maximum annual limit (higher limit for people above 50 years), provided you are satisfied with the investment options and fees offered in the plan. This is because governmental plans are required to be held in trust and therefore when you contribute your money, it is not exposed to creditors of your employer. Whereas non-governmental 457(b) plan is controlled by an employer and your employer has the first right to that money. In other words, if your employer goes bankrupt, it can use the money in your 457(b) plan to pay its creditors. In a governmental 457(b) plan, this would not happen and your money would be safe even if the local or state government declares bankruptcy. This could be one the reason that many physician choose not to use this plan as a tax saving vehicle. However, it must be kept in mind that the risk of this happening is low, especially if you are employed by a large health systems compared to a standalone hospital where your risk is relatively higher. This is a very important and perhaps the most crucial factor that will determine whether you want to contribute to 457(b) plan or not. If you are not comfortable with your money being at-risk or worried about your non-profit organization's  financial situation, you should not be contributing to your non-governmental plan. Having said that, you should study the plan in details and evaluate your risk independently.

Distribution Options

While you study your non-governmental plan in detail, it is also important that you find out about distribution options. Can you withdraw the money as lump sum or have to withdraw in smaller chunks over a certain period? What happens on early retirement? What happens on voluntary or non-voluntary termination? If you change your employer, can you take your plan with you or can leave it with your former employer? These are important questions because every 457(b) plan would be different when it comes to distribution and for the purposes of better tax planning, it is vital to dig deeper into these details before you make a final decision.

Roll Over

While governmental 457(b) allow you to rollover your assets to other eligible retirement plans like 401(k), 403(b), IRAs, a non-governmental plan does not allow this kind of rollover. If you have a non-governmental plan, your only rollover option would be is if your new employer also offers a non-governmental 457(b) and is accepting a rollover.

Loans, Employer Contribution and Roth Contribution

Participant loans, employer contributions and ability to designate all or portion of salary reduction contribution as a Roth contribution are permitted in a governmental 457(b) plan while not permitted in a non-governmental plan. Also, since 457(b) plans are not qualified as retirement plans, sometimes all the fees are not disclosed which can lead to higher fees.

If you are already using this plan, make sure that your try to withdraw the money in 457(b) first for your retirement because this money will remain at-risk even after you retire, provided the distribution options are not going to affect your taxes adversely. Make sure to have an alternate plan if you are invested in a non-governmental 457(b) but planning to leave your employer or worried about being terminated.

Bottom line

In general, non-governmental 457(b) plans have less investor protections compared to a governmental 457(b) plans. If you are being offered a governmental 457(b) plan, you should definitely consider using it for investing and tax saving provided you are satisfied with investment options and fees. If you are being offered a non-governmental 457(b) plan, you should carefully evaluate and study the plan in detail. Avoid reading too much on the internet because every non-governmental 457(b) plan would be different and only your HR department can provide you details on your specific plan. Find out about your investment options, fees, distribution options. Find out about your employer's financial health. Most importantly, determine your own risk tolerance-whether you should contribute a lesser amount instead of maximum annual limit or not at all. Once, you have done a thorough homework and feel confident that your employer is going to be stable and your job will not be in jeopardy with the caveat that your employers and its creditors have the first right to your money, it may be a good option to save taxes and invest. If you don't feel comfortable with money being at-risk or don't like the distribution options, you are better off with not using this plan. After all, any investment that is going to keep you awake at night is not worth it.

To conclude, 457(b) is another good tax saving and investment tool but whether it is a right tool for you or not, only you can answer. Study the plan in detail and then make a final decision according to your individual situation. Hopefully, this article would at least motivate you all to explore this option in more detail if you have not done so already.

Happy saving and happy investing!

Parth Mehta, MD, MPH, FHM is an Adult Hospitalist and a Chief Medical Information Officer at UnityPoint Health at Peoria, IL. Health Care Finance was one his majors during his Masters in Public Health. He believes that physicians in general are not very good with finances and has a special interest in providing financial literacy to those physicians in need and hopes to write a book some day on it.