How to Avoid Taxes on a 457(b) Withdrawal: Strategies and Examples

Planning how and when to withdraw money from your retirement accounts can have a big impact on how much of your savings you actually get to keep. This is especially true with 457(b) plans, which are common for public sector employees. While these accounts offer unique flexibility when compared with other retirement plans, they also come with rules and potential tax pitfalls that can catch you off guard. Understanding how withdrawals are taxed, and the strategies that can help you minimize those taxes, can make a major difference in your long-term financial security.

A financial advisor can review your plan’s rules with you and help create a withdrawal strategy that fits your situation.

Withdrawals from a 457(b) plan are generally taxed as ordinary income in the year they are taken. That means the amount you withdraw gets added to your other taxable income for the year and is subject to your regular federal income tax rate. Unlike Roth accounts, 457(b) contributions are made pre-tax, so both contributions and investment earnings are fully taxable when withdrawn.

One key distinction between 457(b) plans and other types of retirement accounts such as 401(k)s or IRAs is that withdrawals from governmental 457(b) plans are not subject to the 10% early withdrawal penalty, even if taken before age 59½. However, non-governmental 457(b) plans generally do not allow in-service early withdrawals, or they offer them only in very limited situations. Still, avoiding the penalty doesn’t mean avoiding income taxes, which are owed regardless of your age at withdrawal.

In addition to federal income taxes, many states also tax 457(b) withdrawals. The rules vary widely by state, with some exempting retirement income altogether and others applying their standard income tax rates. Understanding your state’s rules is important when projecting how much of your withdrawal you’ll actually keep.

Unlike many other retirement accounts, 457(b) plans allow penalty-free withdrawals once you separate from your government employer, regardless of your age. This makes them attractive for public sector workers or nonprofit employees who may retire early. However, if you are still employed with the sponsoring organization, distributions are generally not available unless the plan specifically permits in-service withdrawals. In most non-governmental 457(b) plans, these in-service withdrawals are not allowed.

The absence of a 10% early withdrawal penalty is one of the biggest advantages of a 457(b) for government employees. Still, every withdrawal is considered taxable income in the year it’s taken. That means you’ll want to plan withdrawals strategically to avoid pushing yourself into a higher tax bracket or creating an unexpected tax bill at year-end.

Like other tax-deferred retirement accounts, 457(b) plans are subject to required minimum distributions (RMDs). Starting at age 73 under current law, you must begin withdrawing a certain percentage each year, which is taxed as income, unless you still work for the employer. Failing to take these mandatory withdrawals can result in steep penalties from the IRS, adding another layer of tax consideration.

Not all 457(b) plans are alike. Governmental 457(b) plans often offer more flexibility, including the ability to roll funds into other types of retirement accounts like IRAs or 401(k)s. Non-governmental 457(b) plans, which are often offered by nonprofit organizations, typically have more restrictions than governmental plans. In many cases, assets cannot be rolled over to an IRA or 401(k), and the plan may require distributions once you leave your employer. Understanding which type of 457(b) you have is essential to following the right withdrawal rules.

If you have a governmental 457(b) plan, you generally have the option to roll your balance into another qualified retirement account such as an IRA, 401(k), or 403(b) without triggering taxes or penalties. As long as the funds move directly from one account to another, the rollover is treated as a tax-free transfer. However, if you take possession of the money first and fail to deposit it into the new account within 60 days, the IRS will consider it a taxable distribution.

Non-governmental 457(b) plans come with much stricter rules. These plans usually cannot be rolled over into IRAs or other employer-sponsored accounts. Instead, distributions must follow the plan’s payout schedule once you leave your job. If you try to move funds outside of what the plan allows, the IRS will treat it as a taxable event, and you could face a large income tax bill in the year of withdrawal.

Even in a permissible rollover, taxes can become a problem if the process isn’t handled correctly. An indirect rollover, where the funds are sent to you first, may trigger mandatory tax withholding—typically 20% of the distribution. If you don’t replace those withheld funds when completing the rollover, that portion is taxed as income. Planning ahead and requesting a direct trustee-to-trustee transfer is the best way to avoid unnecessary tax complications.

When it comes to taking money out of a 457(b) plan, the main challenge is not the 10% early withdrawal penalty, since that does not apply, but managing the ordinary income taxes owed on distributions. Without planning, withdrawals can create large tax liabilities, especially for non-governmental employees. Many non-governmental employers require a full lump-sum distribution at separation, which can generate a significant one-time tax bill. In addition, some non-governmental plans treat funds as taxable as soon as they become available, whether or not you withdraw them. Some governmental employers also require lump-sum distributions unless you actively opt out.

• Time your withdrawals carefully (governmental plans only): For governmental 457(b) plans, withdrawals can often be spread across multiple years. This may help keep you in a lower tax bracket, particularly if you expect lower income in retirement than during your working years.
• Consider a rollover (governmental plans only): If you participate in a governmental 457(b), you may have the option to roll your balance into an IRA or another qualified plan. This provides more flexibility to control the timing of withdrawals and manage taxable income over the long term.
• Take advantage of early withdrawal flexibility: Since 457(b) plans do not impose the 10% early withdrawal penalty, they can be a useful tool for funding early retirement. Using 457(b) funds before tapping IRAs or 401(k)s may help reduce lifetime tax costs if planned carefully.
• Coordinate with other income sources: Plan your 457(b) withdrawals alongside Social Security, pensions, and other retirement accounts. Coordinating these income streams can help avoid spikes in taxable income that might push you into a higher tax bracket or affect Medicare premiums.

The rules differ between governmental and non-governmental 457(b) plans, and in many cases your withdrawal options may be limited. By understanding your plan’s specific rules and planning distributions around your broader income picture, you can better manage taxes and preserve more of your retirement savings.

• A financial advisor can help you determine whether you have enough saved for retirement and recommend strategies to grow your nest egg. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• SmartAsset’s Social Security calculator can help you estimate future monthly government benefits.

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