I’m Allen Giese, President of Northstar Financial Planners in Plantation, Florida. Our firm specializes in helping Miami-Dade fire fighters make better decisions with their money. I want to talk to you today about a huge mistake that we see so many fire fighters make, and most of the time they don’t even realize it. It’s a problem with the deferred comp plan. Like I said, it’s a mistake that we see so many fire fighters make, and as you’ll see in a moment, it costs them thousands of dollars in taxes.
But first off, I want to be really clear and tell you that I think your deferred comp plan is great. It’s awesome! If you’re not utilizing it, and utilizing it fully, then you’re probably missing the boat. But when it comes to the in-service loan provisions, there’s a serious issue.
Now, I know a lot of you think that having the ability to borrow money when you need it against your plan is a great idea, right? I hear all the time that, in the fire station, there’s talk about the advantage being that you’re actually paying yourself back the interest. So that interest you pay actually lands in your account, and basically, you become your own banker. Now, we’ve also seen a lot of you come to us with loans already against your plans, so we know it’s a feature that gets a lot of positive attention.
However, there is something that we find very few of you know that’s happening when you take that loan out. When I explain it to fire fighters about to take the loan, it usually stops them dead in their tracks, and most of the time, they look for another way. They decide that the true cost is just too high—and they’re right. Problem is, nobody at the plan is telling them this incredibly valuable and important piece of information.
So here it is: The big, expensive problem with taking a 457 plan loan is that your money is literally getting taxed twice. Now, getting taxed once is bad enough, but if you take a loan and pay it back, by the time the money has gone through the process, it’s going to get taxed twice. I don’t know anybody that thinks that that’s a good idea.
Take a look at this example. Let’s say we have a fire fighter who wants to take a loan of $25,000. The interest rate is 5%, and the maximum time he or she can pay it back is five years, or 60 months. So that means the monthly payment amount is going to be $471.78 a month, and over that 60 months, he or she will have paid back $28,307 into their account.
Now, here’s a key point: Payments back to your 457 plan are made after tax. Stop and think about that for a second. That means that if the fire fighter is in a 28% income tax bracket and needs to pay back $472, then he or she has to earn $655 before taxes. Or, over the life of the loan, to pay back $28,306, you’d have to earn $39,315. So that means the fire fighter has already paid over $11,000 in taxes.
Now, here’s the second key point: Those dollars that are back in the plan—the dollars that you paid $11,000 in taxes on—they are still considered pre-tax dollars in the plan and are going to be subject to income tax again when you take them out.
I don’t know about you, but that would make me just a little bit angry paying income tax twice on the same dollars. So if you withdraw that same $28,307 out of the plan in retirement, assuming the same 28% tax bracket, you’ll pay an additional $7,925 in taxes. So the total taxes you’ll have paid on that $28,307 that you’ve loaned yourself, paid yourself back, and then subsequently withdrew at retirement, will be a whopping $18,934. Ouch!
Ouch is right. That’s a lot of taxes you’ll pay on those dollars if you take that loan. If you’ve already taken a loan out against your plan, I’m afraid there’s not much you can do to avoid this. But if you are considering a loan and you have any other resources, you might want to seriously look into using those other resources.
Thanks for watching, and I hope this has been helpful. Stay safe, and give us a call if you’re interested in a valuable, complimentary second opinion on your own finances and retirement plan. If you want your own complimentary copy of retired Battalion Chief Gary Gonzalez’s book on how to retire from Miami-Dade Fire, just give us a call or drop us a line.
