As a firefighter, police officer, or paramedic with the Florida Retirement System, you have easy access to a loan on your deferred compensation plan. But think twice before you take out that loan—it can cost you.
We talk to a lot of special risk employees who have taken out a deferred comp loan. Before you become one of them, it’s worth your while to consider all your options. Many FRS special risk employees don’t realize that a deferred comp loan can cost them thousands of dollars in extra taxes.
Why People Take Out Deferred Comp Loans
A deferred comp plan—if you’re utilizing it fully—can be an amazing asset. Also known as a 457 plan, it’s a great way to allow a portion of your withheld pay to grow tax-free until the date that you receive it, usually at retirement.
But when it comes to in-service loan provisions, the plan has a serious drawback. And because of this drawback, our Plantation, FL financial planning firm usually counsels our FRS clients against the loan.
On its face, having the ability to borrow money against your plan when you need it appears to be a great idea. There’s often talk around the fire station or police precinct about the advantage of paying yourself back the interest with a deferred comp loan.
According to common wisdom, the interest you’ll pay on a 457 loan lands back in your account, and you essentially become your own banker. And with the high number of FRS special risk employees who already have loans against their deferred comp plans, it’s obviously a feature that gets a great deal of positive attention.
However, very few eligible employees know what is happening when they take out those loans.
In fact, when firefighters or other FRS special risk employees learn more details of the terms, they usually stop in their tracks. And often, they look for another solution.
They decide the true cost is just too high—and they’re right.
Why a Deferred Comp Loan Isn’t the Best Choice
So what’s the expensive problem with taking a 457 plan loan? Simply put, your money is being taxed twice.
Getting taxed once is bad enough, but by the time you’ve gone through the deferred comp loan process, your money has been taxed a second time.
For example, let’s say you want to take out a loan of $25,000. Let’s assume the interest rate is 5%, and the maximum time you have to pay it back is five years (or 60 months). That means the monthly payment amount is going to be $471.78 per month. Over that 60 months, you will have paid back $28,307 into your account.
What’s wrong with that, you ask? It seems like you’re paying yourself back more money than you started with, right?
Yes, but there are two key problems with this picture:
Payments back to your 457 plan are made after-tax. If you are in a 24% income tax bracket and need to pay back $472, you will need to earn $621 before taxes. To pay back $28,307 over the life of the loan, you’d have to earn $37,245. So you have already paid nearly $9,000 in taxes.
Those dollars are subject to income tax again when you take them out. Because the money in a deferred comp plan is considered pre-tax, you’re taxed according to your tax bracket when you receive your disbursement. So, if you withdraw that same $28,307 in retirement, assuming the same 24% tax bracket, you’ll pay an additional $6,793 in taxes.
In our example, the total taxes you’ll have paid on that $28,307 that you’ve lent yourself, paid yourself back, and then subsequently withdrew at retirement will be a whopping $15,731. Ouch!
If you’ve already taken a loan out against your plan, there’s not much you can do to avoid the pitfalls of a 457 plan loan. But if you are considering a loan and you have other resources, you might want to look seriously into your other options before resorting to a deferred comp loan.
Final Thoughts
While a deferred comp plan has significant benefits for FRS special risk employees, by no means should it be your first choice as a source for a loan.
If you’re interested in a complimentary second opinion on your own finances and retirement plan, or if you want a complimentary copy of retired Battalion Chief Gary Gonzalez’s book on how to retire from Miami-Dade Fire, give us a call at 954-693-0030.
This material was prepared by Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax or legal advice.