There are a lot of posts claiming to talk about what the best account for you to reach FI is. My good buddy the MadFIentist has a few, where he talks about traditional or roth IRAs and how to use your HSA as a retirement account. Of course, he’s assuming that if you’re getting into those strategies you’re maxing out your 401k and taking advantage of your employee match (if you get one).
Unfortunately, the 401k, while a very good retirement tool for avoiding taxes, is not the best out there.
See, the 401k (and it’s non-employer sponsored, lower limited cousin the traditional IRA) both have withdrawal age minimums on them. As you probably already know, you need to be 59.5 to take money out of them tax free. Of course, you can use the Roth IRA conversion ladder, but there is another way.
Read on and I’ll show you how.
First caveat. Many people (from my personal experience) that are interested in FI have a certain personality type, and that personality type tends to shuffle them into employment as computer programmers, engineers or other STEM heavy fields. There are plenty of other people seeking FI in other professions (like the millionaire educator) but in my personal experience, it’s mostly programmers, that work for private companies. What I mean here is that you’re probably unfamiliar with the 457, and for good reason – you don’t have one. 457 plans are only available for government and non-profit workers.
Second caveat. If you do have access to a section 457 plan, aside from the benefits there’s one crucial distinction to this account. This is classified as “deferred compensation“. The major sticking point here is that the funds in the 457 are not yours until you claim them – ie if the non-profit that you work for goes belly up and you’ve got a bunch of money in your 457, that money’s not yours – it belongs to the company and can be accessed by creditors if the situation comes up. I don’t view this to be an issue with government sponsored 457 plans.
What is a 457b Retirement Plan?
These plans work almost the exact same as a 401(k) plan that most private workers have access to, but with a few difference. First, lets go over how they are the same, and how you can use this to your advantage when pursuing FI.
The contribution (at the time of this writing, Q3 2015) limits are the same as they are for 401k plans at $18,000 per year, and have risen in lock step with 401k limit increases. I suspect this will probably continue, but you can never be 100% certain. The plans are funded through voluntary salary reductions, just like a 401k.
Also like a 401k, contributions are pre-tax, and growth is also pre-tax. You won’t be taxed on contributions or gains from the account until you withdraw the money. However at the time you’re ready to withdraw your money, your spending should be well below the long term capital gains tax rate, making the money totally tax free.
So far, sounds pretty much like the 401k right?
Well, here’s where the difference become crucial. There’s no withdraw age minimum for the 457 deferred compensation plans. Let me repeat that so it sinks in: There’s no age minimum to take out your money!
You do need to leave your job to get access to it, but as soon as you do, you can start accessing all the money in your 457 plan. That means no complicated IRA rollovers and conversion to watch for. No trying to figure out how much money you can convert tax free each year. No games, you can just take your money out when you need it, and that’s that.
Now, I’m sure you’re wondering: what does it mean to me, while pursuing FI?
A Financial Independence/Early Retirement Application for 457 Plans
There are a few different ways you can play this, but the most important to think of this as your “bridge” money (the money that you’ll use while you wait for your roth IRA rollover ladder to come through. Typically, this will only need to be for 5 years worth of money, so you can easily figure out how much you’ll need.
I suggest using this only as your bridge money because goverments and non-profits dont really have competitive wages in most cases, so you wont really be able to build up a lot of cash this way. Here’s the first scenario.
You’re about 3-4 years away from FI, but most of your money is trapped in age limited retirement accounts, with not much in a post tax account. You can take a lower paying job with the government or NGO that offers a 457 plan, and max it out for 4 years, giving you $72,000 in contributions at the end of year four. You’ll have whatever gains that have happened in the market over the last for years and if you end up in a government position, you’ll have a pension! You can take whatever is in your pension balance and roll it over into your 457 as well, giving you an even larger balance. A few numbers as an example (over a 4 year career in government):
- 457 Contributions: $72,000
- Pension assets (I averaged about 5k/yr here in wyoming, so i’ll use that): $15,000
- Gains: ~10k (over the 4 year working period)
Since your salary has been lower than it was before the job switch, you can convert some of your pre-tax IRA money to post tax, up to the tax free limit for your family situation. This could be a good way to get at some of your FI funds a bit sooner.
An Early Career Move (My Path)
I worked for the government from 2011 to 2014, and I had access to a 457 plan (as well as a pension) the entire time. Unfortunately, I didnt get as much money in here as I would have liked as I was busy paying off debt, but once that had finished I had started to increase my contributions and get more money put in there. It wasnt long (just a few months) that I decided to switch jobs and my option of a 457 went away. Here’s what I did, and how I think it will help me with FI when the time comes:
- Contributed a bit (like $100/mo) to my 457 until debt was paid off
- Had about 2 months of 750/mo contributions
- Rolled pension account (I wasnt vested) into my 457
All of those manuvers left me with about 1 year of living expenses post FI in the account, and I’m not anywhere near retirement. At this point, I suspect I’m around 9-10 years out, depending on market returns. Assuming a 6% rate of return, this money will about double, and will probably provide for about 2 years of living expenses when I’m ready to tap them – giving me more time to run my roth conversion ladder and more time for me to grow my after tax stash.
I know that these accounts are not that popular and most people dont know about them, but the high contribution limits and the fact that there’s no minimum withdraw age make them prime candidates for FI accounts. If you live in the right area and are interested, taking a government job for all of your working years could be a great idea. You could get into the 457 plan, have a pension to kick in a bit of old age money, and enjoy a relatively low-stress lifestyle. Of course, you’d have to deal with all the things that come with government work too.
The choice is yours for those of you interested in FI, but personally, I think the 457 makes a pretty compelling case.