Tax Benefits

What are the tax benefits of 457 Deferred Compensation?

In addition to the benefits of tax-deferred contributions and tax-deferred growth, described below, you may be eligible for a tax credit on all, or a portion of your contributions. These tax credits were included in the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, and are designed to encourage low and middle-income taxpayers to establish or maintain a supplemental retirement savings account. The amount of this credit depends upon your filing status and Adjusted Gross Income (AGI). The credit may be used against regular income tax liability, and is in addition to the deduction from gross income for the tax-deferred contribution (described below). The maximum credit is 50% of the amount saved up to $2,000 of savings (per individual). The amount of the credit can be determined by using the table below. Please contact CCOERA or your tax advisor for more information on tax credits.

Tax-Deferred Contributions

When you invest money using a conventional savings method, such as a savings account, you pay income taxes on the money before you receive it to invest. When you invest money through your employer's 457 Deferred Compensation Plan, the contributions are deducted from your paycheck before federal and state income taxes are calculated. This deduction immediately lowers your taxable income, thereby reducing the amount you pay in taxes. These tax savings can be invested in your Deferred Compensation Plan – a tax strategy that helps your money grow faster.

Another Way to Look at Tax-Deferred Contributions...

The chart aboves demonstrates how the income tax savings that were discussed in the previous section can be used as an additional investment in your account.

This example shows how a person that is saving $100 per pay period in an after-tax investment, could instead save $130 through Deferred Compensation, and have the same net (take-home) pay. How is this possible? Remember, the Deferred Compensation contribution is deducted before federal and state income taxes are calculated. These tax savings are invested in the Deferred Compensation Plan by increasing the contribution amount. The end result is an extra $30 every pay period to save for retirement.

Tax-Deferred Growth

The second tax benefit that you'll realize immediately by saving through your 457 Deferred Compensation Plan is tax-deferred growth. This means that any tax liability on the earnings and investment return you accrue in your Deferred Compensation account is deferred until withdrawal. In a traditional savings vehicle, like a bank savings account, you receive a 1099-INT at the end of each year, which states the amount of interest that you earned in that account for the taxable year. You then have to report those earnings as taxable income for the year, and pay federal and state income taxes on those earnings.

Comparing After-Tax Growth to Tax-Deferred Growth

You've seen how Deferred Compensation can reduce your federal and state income taxes each paycheck and at the end of the year. Now, let's look at what a difference tax-deferred growth can make over time.

Why Does a Tax-Deferred Investment Grow Faster Than an After-Tax Investment?

When you earn interest on an investment in an after-tax account, you have to report the interest or investment return as taxable income and pay income taxes on the gain each year. However, when you invest in your employer's Deferred Compensation Plan your earnings are tax-deferred. That means that the money you would have withdrawn from your after-tax account to pay income taxes each year, stays invested in your account to generate additional investment return. Left to grow tax-deferred for many years, this tax strategy can put substantially more money in your account for retirement.

The example shown below illustrates the dramatic difference that investing in a Deferred Compensation Plan can make over time. This example assumes that the same amounts shown in the previous illustration ($100 After-Tax & $130 Deferred Compensation) are invested each year and that both accounts earn an 8% annual return. It also assumes that the income tax rate is 28%.

Comparing After-Tax Growth to Tax-Deferred Growth

You've seen how Deferred Compensation can reduce your federal and state income taxes each paycheck and at the end of the year. Now, let's look at what a difference tax-deferred growth can make over time.

When Do I Pay Taxes On The Money In My Account?

As mentioned in the previous section, taxes on contributions and earnings in your 457 Deferred Compensation Plan are deferred until you receive a distribution. You will pay taxes only on the amount you receive from your account each taxable year.

How Much Income Tax Will I Pay?

Taxes on all Deferred Compensation Plan distributions are taxable as ordinary income. The amount of income tax an individual pays will vary based on their total income for the year. Federal income tax rates are graduated based on your annual taxable income. Therefore, a person with a higher income will pay a greater percentage of their income in taxes. When a participant receives a lump-sum distribution it may result in a higher tax bracket. Therefore, its generally in your best interest to have your Deferred Compensation Plan distribution spread out over several years rather than receiving a lump-sum distribution.

If I Pay Taxes At The Same Rate When I Retire, Do I Benefit From The Tax-Deferred Status Of The Plan Upon Distribution?

Yes. Remember, one of the potential benefits of Deferred Compensation is the ability to defer a portion of your income while you are in your peak earning years, and instead pay taxes during retirement, when you may be in a lower tax bracket.

The chart shown below illustrates how beneficial the power of tax-deferred investing can be – even if you pay taxes at the same rate as when they were deferred.

This chart shows the monthly amount an investor would receive from the purchase of a twenty-year period-certain annuity, with a 7.50 percent purchase rate. This illustration assumes that the tax-deferred investor pays taxes at a flat rate of 28%.