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Now, I have made a lot of mistakes throughout my life dealing with finances. From digging myself a large debt hole to not maxing out all retirement accounts, but one of the biggest mistakes that I have made is not understanding the 457 deferred compensation plan.
My mom works at a hospital and she receives comp time. Comp time is how they pay my mom overtime. They don’t pay her overtime, instead they save the extra time that she worked in comp time bank and this becomes time that she can use for vacations.
When my wife and I first got married, her place of employment (hospital) offered two plans. A 401k and a 457. The worrisome thing about the 457 was two words after the numbers, “deferred compensation.” This sounded too much like my mother’s comp time plan at her work and I really didn’t want my wife’s income just sitting in an account waiting to be used.
I never did any research and just avoided the 457 plan in my wife’s retirement plan. However, we did not ignore retirement and invested in my wife’s 401k. Am I mad that we invested in my wife’s 401k? No. The 401k is a great vehicle for retirement investing and I would not change the way we invested in the 401k. I just wish we would have started investing in the 457 before November of 2018.
What is a 457 Deferred Compensation Plan?
A 457 deferred compensation plan is a retirement vehicle that is offered to public service employees.
Employees at a Government hospital like a county hospital (Nurses, etc)
Any other type of public employee.
A 457 allows you to invest in the account with pre-tax dollars, just like a 401k or 403b. Essentially, this allows you to save for retirement in an extra account, besides the 401k or the 403b, while also saving on the taxes. Anything you put in the 457 will be taxed when you take it out, but you avoid the taxes in the current calendar year as you invest.
Having access to the 457 allows government employees the option to double the amount that they invest pre-tax dollars. This essentially lowers your tax basis in the current calendar year and lowers the overall amount you will pay in taxes.
So, it’s essentially a second 401k or 403b?
Yes, you can invest in a 457, just like a 401k or a 403b. However, there is one major difference that sets the 457 apart from the 401k or 403b. A 401k or 403b requires that you wait until 59 and a half years old before you can use the money. If you take the money out before 59.5, then you are hit with the tax rate and a 10% penalty.
The 457 does not have this stipulation. You can take the money out whenever, without being hit with the 10% penalty. You will be hit with income tax. The hard part is that it is difficult to take the money out while working for an employer, but you have access to the money once you are no longer employed. This is called separation of service and this allows you to access the money in the 457 or you could also roll it over into an IRA.
However, once you roll it over to an IRA, you are required to follow the 59.5 rule before you can touch the money without a penalty. I would suggest avoiding rolling it over to a IRA, because money in the 457 essentially becomes a large emergency fund. It’s money that you can access whenever you need without worrying about the 10% penalty.
How would I use this 457, if I can’t access it until I leave my job?
I have three examples in mind on how using a 457 can benefit you before the age of 59.5. Now, this may not be for some people. Some people will not be interested in leaving their job before 59.5. That’s cool, more power to you, but some people don’t want to work all the way until age 59.5. Some people want freedom and that’s what money can give you.
Example #1: Retire for work at age 50.
This was not a far fetched plan for teachers in Texas with the way that the retirement system was set up. It was set up with the rule of 80 (age + years of service). Once these two numbers hit 80, you could retire and receive the full benefit. Now, the law has changed a bit requiring teachers to work until 60 to receive the full benefit. However, I want to use the rule of 80, because many educators in Texas still fall under this rule (only younger teachers fall under the later provision).
I used my age to figure out years of service and my age. If I work 29 years, I would be 52 at the end of my 29th year (52 + 29 = 81). Under the old provisions of TRS, I could have retired at 52 and received the full TRS benefit. Retiring at 52 leaves a 7.5 year gap between accessing your 401k, 403b or IRA money without being charged the 10% penalty.
Therefore, the 457 fund would be great to have in this scenario. You can retire at 52, live on the TRS Pension and supplement your retirement income with the 457 money until you reach 59.5. The 457 is a great way to build a gap fund, if you intend to retire before age 59.5.
Despite the law changes with the TRS, I am not too worried about retiring early. This is why my wife and I dump loads of money into our 401k, 403b and 457 plans. We want to be able to retire on our own terms and not wait on some law that the government has dictated as our retirement age. Retirement is a financial number, not an age.
Therefore, I am looking at using our 457 funds as a way to bridge a gap between our retirement date and the governments defined terms of retirement.
Example #2: Taking a Gap Year or Mini-Retirement
Some people may think this is crazy and it may be a little crazy, but what’s wrong with thinking outside the box? My wife and I have discussed the possibility of a gap year. Our idea with this gap year is to be able to spend more time with my family in Nebraska. Allow my daughters to spend more time with their grandparents and great grandparents while they are young.
Therefore, we are looking at the 457 plans as a way to fund a gap year. This would allow us to leave our jobs for a year and just hang out as a family. We would use the 457 money to fund our one year adventure with out work. All along our money in other retirement accounts will be sitting there growing and growing some more!!
Sure, we may hurt our financial position a little, but family time and time is finite. We can always go back to work, but you are not guaranteed that next day, therefore, we want to live our lives and not just live to work.
Example #3: The Millionaire Educator Plan
Ed Mills, a teacher in Georgia, is the mad genius behind using the 457 to help fund his life. Initially, he had to build up his 457 funds, but after 7 years of saving and building at his first job, he left and went to a small town to teach. He used the separation of service clause to help him.
Him and his wife lived on the money from their 457 plans (about 90k) from their previous jobs, while investing all of their income from their current teaching jobs. Using this plan, they save around 130K of their income while living on approximately 30K of their 457 money from their previous jobs each year.
They worked for 3 years and then left again. This time they took an entire year off and spent an extended trip living internationally. He is currently back working, but he still doesn’t live on his income from his teaching job, Instead he is dumping all of his money into retirement accounts and living off of 457 and using 72T distributions.
Essentially, he uses money that he has saved at other jobs to live on, while taking advantaged of the tax-deferred investing that you can find from working. This has benefited him and his family, because they control their income, their effective tax rate and they have reached over a million dollars in net worth.
Ed Mills has laid out a great plan for any teachers out there. Specifically, in the realm of building up so much money that you can live on while using your income to invest. I discovered this while listening to Ed on the ChooseFI podcast.
During this interview, he stated that him and his wife were getting burnt out of teaching and needed a break. That’s why after 10 years of working, they left their jobs and took a year off. Sure, we get a summer off as teachers, but a year off is exactly what you may need to recharge the batteries.
What’s Our Plan?
After discovering the awesomeness of the 457, my wife and I jumped right into investing. I will be crossing over my ten year mark of working as a teacher and my wife will be crossing over 9 years of working as a nurse.
About 2 years ago, I was burnt out and I wanted a break. I never jumped ship and lately I have been enjoying my job. So, we are building up both 457 accounts in the anticipation of 3 possibilities.
We have a 3rd child. My wife could stay home and we can use her 457 money to supplement our family income. Specifically, my plan is to use her 457 to pay the mortgage, while we use my teaching salary to live on.
We take a gap year. We have discussed this possibility, because both of our great grandparents are getting up there in age and we want to spend more time with them. Specifically, we want to spend more time as a family, but also give our daughters the opportunity to spend more time with their grandparents and great grandparents. We had talked about at the end of next year, but I am contemplating pushing it back one more year (to build up our 457s even more).
Do nothing, keep working and building up our 457s. We can decide at a later date our plan for leaving or taking a gap year. In this scenario, we would wait until we have at least 90K in 457 money before changing jobs (approx. 17% to 90K)
The 457 deferred compensation plan is a great tool to add to your investing plan. It is so versatile and it allows you the ability to invest extra tax deferred money, while also cutting you tax bill. This fund is a fund that all educators and public service employees need to use.
What are your thoughts? Would you use the 457 fund the same way that Ed did or would you just build it up with the plan to retire early?