What Is a 457 Plan?

A 457 plan is a tax-advantaged retirement savings plan offered to employees of many state and local governments and some nonprofit organizations. Like the better-known 401(k) plan in the private sector, the 457 plan allows employees to deposit a portion of their pre-tax earnings in an account, reducing their income taxes for the year while postponing the taxes due until the money is withdrawn after they retire.

A Roth version of the 457 plan, which allows after-tax contributions, may be allowed at the employer’s discretion.

There are two main types of 457 plans:

• The 457(b): This is the most common 457 plan and is offered to state and local government employees and nonprofits. It is a retirement savings plan that offers tax advantages to participants.
• The 457(f): This plan is offered only to highly compensated executives in tax-exempt organizations. It is a supplement to the 457(b) and it is, essentially, a deferred salary plan.

Types of 457 Plans

As noted, the 457 plan comes in two flavors, the 457(b) and the 457(f).

The 457(b) Plan

The 457(b) plan is most often offered to civil servants, police personnel, and other employees of government agencies, public services, and nonprofit organizations such as hospitals, churches, and charitable organizations.

It is similar to a 401(k). Participants set aside a percentage of their salary into a retirement account. The employees choose how their money is invested from a list of options, mostly mutual funds and annuities.

The account grows in value without being taxed over the years. When the employee retires, taxes will be due on the amount withdrawn.

Employees are allowed to contribute up to 100% of their salary, provided it does not exceed the dollar limit set for the year.

457(b) Contribution Limits

As of 2022, employees can contribute up to $20,500 per year to 457 plans. This limit increases to $22,500 for 2023.

In some cases, workers are allowed to contribute even more. For example, if an employer permits catch-up contributions, workers over the age of 50 may pay in an additional $6,500 a year, making their maximum contribution limit $27,000 ($20,500 + $6,500) in 2022. The catch-up contribution increases to $7,500 for tax year 2023, making the maximum contribution limit $30,000 ($22,500 + $7,500).

Also, 457(b) plans feature a “double limit catch-up” provision. This is designed to allow participants who are nearing retirement to compensate for years in which they did not contribute to the plan but were eligible to do so.

In this case, employees who are within three years of retirement age may contribute up to $41,000 in 2022 and up to $45,000 in 2023. 

Advantages and Disadvantages of a 457(b) Plan

The 457(b) plan has all of the advantages of a 401(k), although there are some differences.

Advantages of a 457(b)

Tax Benefits

If a traditional rather than a Roth plan is chosen, the contributions are deducted from an employee’s paycheck on a pre-tax basis. That amount is subtracted from the employee’s gross income, effectively lowering the person’s taxes paid for that year. For example, if Alex earns $4,000 per month and contributes $700 to a 457(b) plan, Alex’s taxable income for the month is $3,300.

Employees invest their contributions in their choice or choices from a selection of annuities and mutual funds.

All interest and earnings generated from year to year remain untaxed until the funds are withdrawn.

Withdrawals Without Penalty

There is one big difference between the 457(b) and other tax-advantaged retirement plans: no penalty for early withdrawals in some circumstances.

If an employee retires early or resigns from the job for any reason, the funds can be withdrawn without incurring a 10% penalty from the IRS. Early withdrawals from most retirement plans are subject to the penalty except for certain hardship reasons. (The penalty was waived for two years during the COVID-19 pandemic.) 

A 457(b) account holder can take a penalty-free withdrawal without changing jobs, like a 401(k) account holder. The list of acceptable reasons, however, is limited to “unforeseeable emergencies.”

Exceptions to the Rules

Early withdrawals from a 457(b) are subject to the 10% penalty if the account holder rolls the funds over from a 457 to any other tax-advantaged retirement account, such as a 401(k). This would happen if, for example, a government employee quit to take a job in the private sector.

In addition, anyone who takes money out of a retirement account early must keep in mind that any income taxes due on that money will be owed in the year that the withdrawal is taken.

Disadvantages of a 457(b) Plan

One potential advantage of most tax-advantaged retirement savings plans is the employer match. An employer may choose to match some portion of an employee’s contribution to the plan. An employer who matches the first 3% of the employee’s contribution, for example, is presenting the employee with a 3% raise.

Employer Match Is Rare

Employers can match their employees’ contributions to a 457(b) but, in practice, most don’t.

If they do, the employer contribution counts toward the maximum contribution limit. This is not the case for 401(k) plans.

For instance, in 2022, if an employer contributes $10,000 to a 457(b) plan, the employee can add only $10,500 for the year until the $20,500 contribution limit is reached (except for those eligible to use the catch-up option).

457(b) vs. 403(b)

The 403(b) plan, like the 457(b), is mostly available to public service employees. They are a particularly common benefit offered to public school teachers.

The 403(b) has its origins in the 1950s when it exclusively offered an annuity to participants. Participants still have the option of creating an annuity but they also can choose to invest in mutual funds.

In fact, the 403(b) has changed over the years until it closely resembles the private sector’s 401(k) plan, although the investment choices offered to participants are relatively limited.

The annual contribution limits are identical to those of the 457(b) and 401(k) plans.

If you’re a public employee, your employer may well offer a 457(b) or a 403(b).

What Is a 529 Plan?

A 529 plan is a tax-advantaged savings plan designed to help pay for education. Originally limited to postsecondary education costs, it was expanded to cover K-12 education in 2017 and apprenticeship programs in 2019.

The two major types of 529 plans are education savings plans and prepaid tuition plans.

Education savings plans grow tax-deferred, and withdrawals are tax-free if they’re used for qualified education expenses. Prepaid tuition plans allow the account owner to pay current tuition rates for future attendance at designated colleges and universities. That means that, most likely, you can lock in a lower cost of college attendance.

529 plans are also referred to as qualified tuition programs and Section 529 plans.

Understanding 529 Plans

Although 529 plans take their name from Section 529 of the federal tax code, the plans themselves are administered by the 50 states and the District of Columbia.

Anyone can open a 529 account, but they are typically established by parents or grandparents on behalf of a child or grandchild, who is the account’s beneficiary.

In some states, the person who funds the account may be eligible for a state tax deduction for their contributions.

The money in a 529 plan grows on a tax-deferred basis until it is withdrawn. What’s more, as long as the money is used for qualified education expenses as defined by the IRS, those withdrawals aren’t subject to either state or federal taxes. In addition, some states may offer tax deductions on contributions.

In the case of K-12 students, tax-free withdrawals are limited to $10,000 per year.

Since tax benefits vary depending on the state, it’s important that you check the details of any 529 plan to understand the specific tax benefits that you may or may not be entitled to.

Types of 529 Plans

The two main types of 529 plans have some significant differences.

Education Savings Plans

529 savings plans are the more common type. The account holder contributes money to the plan. That money is invested in a pre-set selection of investment options.

Account-holders can choose the investment (usually mutual funds) that they want to invest in. How those investments perform will determine how much the account value grows over time.

Many 529 plans offer target-date funds, which adjust their assets as the years go by, becoming more conservative as the beneficiary gets closer to college age.

Withdrawals from a 529 savings plan can be used for both college and K-12 qualified expenses. Qualified expenses include tuition, fees, room and board, and related costs.

The SECURE Act of 2019 expanded tax-free 529 plan withdrawals to include registered apprenticeship program expenses and up to $10,000 in student loan debt repayment for both account beneficiaries and their siblings.

And the SECURE Act of 2022, passed as part of the 2023 Omnibus funding bill, will permit rolling over up to $35,000 of unspent funds in a 529 account into a Roth IRA account, starting on Jan. 1, 2024. To qualify, the account must be at least 15 years old,

Prepaid Tuition Plans

Prepaid tuition plans are offered by a limited number of states and some higher education institutions. They vary in their specifics, but the general principle is that they allow you to lock in tuition at current rates for a student who may not be attending college for years to come. Prepaid plans are not available for K-12 education.

As with 529 savings plans, prepaid tuition plans grow in value over time. Eventual withdrawals from the account used to pay tuition are not taxable. However, unlike savings plans, prepaid tuition plans do not cover the costs of room and board.

Prepaid tuition plans may place a restriction on which colleges they may be used for. The money in a savings plan, by contrast, can be used at almost any eligible institution.

In addition, the money paid into a prepaid tuition plan isn’t guaranteed by the federal government and may not be guaranteed by some states. Be sure you understand all aspects of the prepaid tuition plan.

Tax Advantages of 529 Plans

Withdrawals from a 529 plan are exempt from federal and state income taxes, provided the money is used for qualified educational expenses.

Any other withdrawals are subject to taxes plus a 10% penalty, with exceptions for certain circumstances, such as death or disability.

The money you contribute to a 529 plan isn’t tax deductible for federal income tax purposes. However, more than 30 states provide tax deductions or credits of varying amounts for contributions to a 529 plan.

In general, you’ll need to invest in your home state’s plan if you want a state tax deduction or credit. If you’re willing to forgo a tax break, some states will allow you to invest in their plans as a nonresident.

Advantages and Disadvantages of 529 Plans

What Is an Accrued Expense?

An accrued expense, also known as accrued liabilities, is an accounting term that refers to an expense that is recognized on the books before it has been paid. The expense is recorded in the accounting period in which it is incurred.

Understanding Accrued Expenses

Since accrued expenses represent a company’s obligation to make future cash payments, they are shown on a company’s balance sheet as current liabilities. An accrued expense can be an estimate and differ from the supplier’s invoice that will arrive at a later date. Following the accrual method of accounting, expenses are recognized when they are incurred, not necessarily when they are paid.

An example of an accrued expense is when a company purchases supplies from a vendor but has not yet received an invoice for the purchase. Other forms of accrued expenses include interest payments on loans, warranties on products or services received, and taxes—all of which have been incurred or obtained, but for which no invoices have been received nor payments made. Employee commissions, wages, and bonuses are accrued in the period they occur although the actual payment is made in the following period.

Accrual vs. Cash Basis Accounting

Accrual accounting differs from cash basis accounting, which records financial events and transactions only when cash is exchanged—often resulting in the overstatement and understatement of income and account balances.

Although the accrual method of accounting is labor-intensive because it requires extensive journaling, it is a more accurate measure of a company’s transactions and events for each period. This more complete picture helps users of financial statements to better understand a company’s present financial health and predict its future financial position.

Accrued Expenses vs. Prepaid Expenses

Accrued expenses are the opposite of prepaid expenses. Prepaid expenses are payments made in advance for goods and services that are expected to be provided or used in the future. While accrued expenses represent liabilities, prepaid expenses are recognized as assets on the balance sheet. This is because the company is expected to receive future economic benefit from the prepayment.

On the other hand, an accrued expense is an event that has already occurred in which cash has not been a factor. Not only has the company already received the benefit, it still needs to remit payment. Therefore, it is literally the opposite of a prepayment; an accrual is the recognition of something that has already happened in which cash is yet to be settled.

Advantages and Disadvantages of Accrued Expenses

Advantages

Accrued expenses theoretically make a company’s financial statements more accurate. While the cash method is more simple, accrued expenses strive to include activity that may not have fully been incurred but will still happen. Consider an example where a company enters into a contract to incur consulting services. If the company receives an invoice for $5,000, accounting theory states the company should technically recognize this transaction because it is contractually obligated to pay for the service.

Accrued expenses also may make it easier for companies to plan and strategize. Accrued expenses often yield more consistent financial results as companies can include recurring transactions in their financial reports that may not yet have been paid. In addition, accrued expenses may be a financial reporting requirement depending on the company and their Securities and Exchange Commission filing requirements.

Disadvantages

Because of additional work of accruing expenses, this method of accounting is more time-consuming and demanding for staff to prepare. There is a greater chance of misstatements, especially is auto-reversing journal entries are not used. In addition, a company runs of the risk of accidently accruing an expense that they may have already paid.

Last, the accrual method of accounting blurs cash flow and cash usage as it includes non-cash transactions that have not yet impacted bank accounts. For a large company, the general ledger will be flooded with transactions that report items that have had no bearing on the company’s bank statement nor impact to the current amount of cash on hand.

Special Considerations

Reversing Entries

A critical component to accrued expenses is reversing entries, journal entries that back out a transaction in a subsequent period.

Accrued expenses are not meant to be permanent; they are meant to be temporary records that take the place of a true transaction in the short-term. Every accrued expense must have a reversing entry; without the reversing entry, a company risks duplicating transactions by recording both the actual invoice when it gets paid as well as the accrued expense.

Month-End/Year-End

Accrued expenses are prevalent during the end of an accounting period. A company often attempts to book as many actual invoices it can during an accounting period before closing its accounts payable ledger. Then, supporting accounting staff analyze what transactions/invoices might not have been recorded by the AP team and book accrued expenses.

For companies that are responsible for external reporting, accrued expenses play a big part in wrapping up month-end, quarter-end, or fiscal year-end processes. A company usually does not book accrued expenses during the month; instead, accrued expenses are booked during the close period.

Example of Accrued Expense

A company pays its employees’ salaries on the first day of the following month for services received in the prior month. So, employees that worked all of November will be paid in December. If on Dec. 31, the company’s income statement recognizes only the salary payments that have been made, the accrued expenses from the employees’ services for December will be omitted.

Because the company actually incurred 12 months’ worth of salary expenses, an adjusting journal entry is recorded at the end of the accounting period for the last month’s expense. The adjusting entry will be dated Dec. 31 and will have a debit to the salary expenses account on the income statement and a credit to the salaries payable account on the balance sheet.

When the company’s accounting department receives the bill for the total amount of salaries due, the accounts payable account is credited. Accounts payable is found in the current liabilities section of the balance sheet and represents the short-term liabilities of a company. After the debt has been paid off, the accounts payable account is debited and the cash account is credited.

The Bottom Line

Companies using the accrual method of accounting recognize accrued expenses, costs that have not yet been paid for but have already been incurred. Accrued expenses make a set of financial statements more consistent by recording charges in specific periods, though it takes more resources to perform this type of accounting. While the cash method of accounting recognizes items when they are paid, the accrual method recognizes accrued expenses based on when service is performed or received. 

What Is Active Management?

The term active management means that an investor, a professional money manager, or a team of professionals is tracking the performance of an investment portfolio and making buy, hold, and sell decisions about the assets in it. The goal of any investment manager is to outperform a designated benchmark while simultaneously accomplishing one or more additional goals such as managing risk, limiting tax consequences, or adhering to environmental, social, and governance (ESG) standards for investing. Active managers may differ from other is how they accomplish some of these goals.

For example, active managers may rely on investment analysis, research, and forecasts, which can include quantitative tools, as well as their own judgment and experience in making decisions on which assets to buy and sell. Their approach may be strictly algorithmic, entirely discretionary, or somewhere in between.

By contrast, passive management, sometimes known as indexing, follows simple rules that try to track an index or other benchmark by replicating it. Those who advocate for passive management maintain that the best results are achieved by buying assets that mirror a particular market index or indexes. Their contention is that passive management removes the shortfalls of human biases and that this leads to better performance. However, studies comparing active and passive management have only served to keep the debate alive about the respective merits of either approach.

Understanding Active Management

Investors who believe in active management do not support the stronger forms of the efficient market hypothesis (EMH), which argues that it is impossible to beat the market over the long run because all public information has already been incorporated in stock prices.

Those who support these forms of the EMH insist that stock pickers who spend their days buying and selling stocks to exploit their frequent fluctuations will, over time, likely do worse than investors who buy the components of the major indexes that are used to track the performance of the wider markets over time. But this point of view narrows investing goals into a single dimension. Active managers would contend that if an investor is concerned with more than merely tracking or slightly beating a market index, an active management approach might be better suited for the task.

Active managers measure their own success by measuring how much their portfolios exceed (or fall short of) the performance of a comparable unmanaged index, industry, or market sector.

For example, the Fidelity Blue Chip Growth Fund uses the Russell 1000 Growth Index as its benchmark. Over the five years that ended June 30, 2020, the Fidelity fund returned 17.35% while the Russell 1000 Growth Index rose 15.89%. Thus, the Fidelity fund outperformed its benchmark by 1.46% for that five-year period. Active managers will also assess portfolio risk, along with their success in achieving other portfolio goals. This is an important distinction for investors in retirement years, many of whom may have to manage risk over shorter time horizons.

Strategies for Active Management

Active managers believe it is possible to profit from the stock market through any of a number of strategies that aim to identify stocks that are trading at a lower price than their value merits. Their strategies may include researching a mix of fundamental, quantitative, and technical indications to identify stock selections. They may also employ asset allocation strategies aligned with their fund’s goals.

Many investment companies and fund sponsors believe it’s possible to outperform the market and employ professional investment managers to manage the company’s mutual funds. They may see this as a way to adjust to ever-changing market conditions and unprecedented innovations in the markets.

Disadvantages of Active Management

Actively managed funds generally have higher fees and are less tax-efficient than passively managed funds. The investor is paying for the sustained efforts of investment advisers who specialize in active investment, and for the potential for higher returns than the markets as a whole.

An investor considering active management should take a hard look at the actual returns after fees of the manager.

Advantages of Active Management

A fund manager’s expertise, experience, and judgment are employed by investors in an actively managed fund. An active manager who runs an automotive industry fund might have extensive experience in the field and might invest in a select group of auto-related stocks that the manager concludes are undervalued.

Active fund managers have more flexibility. There is more freedom in the selection process than in an index fund, which must match as closely as possible the selection and weighting of the investments in the index.

Actively managed funds allow for benefits in tax management. The flexibility in buying and selling allows managers to offset losers with winners.

Managing Risk

Active fund managers can manage risks more nimbly. A global banking exchange-traded fund (ETF) may be required to hold a specific number of British banks. That fund is likely to have dropped significantly following the shock Brexit vote in 2016. An actively managed global banking fund, meanwhile, might have reduced its exposure to British banks due to heightened levels of risk.

Active managers can also mitigate risk by using various hedging strategies such as short selling and using derivatives.

Active Management Performance 

There is plenty of controversy surrounding the performance of active managers. Their success or failure depends largely on which of the contradictory statistics is quoted.

Over 10 years ending in 2021, active managers who invested in domestic small growth stocks were most likely to beat the index. A study showed that 88% of active managers in this category outperformed their benchmark index before fees were deducted.