Firefighters Face Unique Challenges with Deferred Comp

If you’re a firefighter who’s saving for retirement via your deferred compensation (457) plan, you’ve probably told your non-firefighter friends who have 401(k)s that your deferred comp is pretty similar.

And it is. The money you put into your deferred comp each paycheck goes into your deferred comp account without you having to pay income taxes on it. That’s just like a 401(k). Your deferred comp balance grows tax-deferred, until you withdraw money from it. But what you — and your 401(k) friends — probably aren’t thinking about while you’re working is that when it’s time to take the money out of your deferred comp plan, you’ll owe ordinary (earned) federal income taxes on your money.

Even if you don’t need the money, the IRS will make you start taking money out of your deferred comp plan at age 72, and the IRS will assess ordinary (earned) federal income taxes on every penny … because you’ve never paid a penny of federal income tax on any of the money that’s in your deferred comp plan.

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And if you leave your deferred comp to your kids, they’ll inherit not only your deferred comp, but they’ll also be on the hook with the IRS for the federal income taxes that you never paid as the money is forced out of the plan. That can push your kids into a higher federal tax bracket.

Triple Tax Trouble

Not only is your monthly pension federally taxable as earned income, your deferred comp is taxed in retirement by the IRS as earned income as well. And let’s say you’re married, and your spouse has Social Security. Your federally taxable income from your pension, and from your deferred comp, can make up to 85% of your spouse’s Social Security federally taxable as well.

Because most fire departments are on the one-on/two-off schedule, you may have a side job, so maybe you were able to stuff away much of your fire department pay into your deferred comp plan.

Odds are the guys at the firehouse, the union and your deferred comp rep all have said that the smartest thing to do was to jam as much money as possible into your deferred comp. Your accountant probably agreed because it kept your taxable income down each year.

But what the guys at the firehouse, the union, the deferred comp rep and even your accountant probably aren’t asking themselves is, “What happens when you’re retired?”

You Need a Plan to Manage Taxes Through Retirement

Accountants are great at accounting. Or in looking at this year’s tax liability. Or last year’s tax liability. But accountants aren’t financial planners. They don’t specialize in minimizing income taxes 10 or 20 years from now. They tend to use the rearview mirror, but not the windshield.

Without a well-thought-out retirement tax-reduction plan, you may very well end up paying a considerable amount of federal income taxes in retirement. And when federal tax rates go up in 2026, as is current federal law under the Tax Cuts & Jobs Act of 2017 (TCJA), you could be shocked at the federal tax bracket that you find yourself in.

How high could federal income tax rates go? Well, in 1944, the top federal income tax rate was 94% on taxable income (which is what deferred comp is) over $200,000. And, over the next three decades, the top federal income tax rate never dropped below 70%. Today, the top federal income tax rate is 37% under the Tax Cuts & Jobs Act of 2017. But when the TCJA’s tax cuts end at the end of 2025, federal income tax rates go back up.

Your non-firefighter friends and relatives with their traditional 401(k)s, 403(b)s and IRAs face the same problem with their tax-deferred accounts, too. But do they also have a federally taxable monthly pension?

Tax Strategies to Consider

The good news is that there are ways to restructure your deferred comp so that the IRS has as little impact upon your retirement funds as is possible.

The exact right strategy for you will vary based upon how old you are now, when you plan to retire, or if you’re already retired, and other factors. But the goal is the same: to turn tax-deferred savings in your deferred comp plan into tax-free retirement income.

Here are a couple of possibilities to consider:

One strategy that might work for you is transferring money from deferred comp to a traditional IRA, then converting to a Roth over a prescribed period of time.

Something most folks don’t seem to know is that you can perform Roth conversions at any age, at any income and with any amount, so this is not something you want to put off considering. This is especially true as the Trump tax cuts are set to expire at the end of 2025.

Please keep in mind that a Roth conversion is a federally taxable event and may have several tax-related consequences. So it’s recommended that you consult with your financial planner, as well as your tax professional, before making any decisions regarding Roth conversions.

Don’t Forget Your Legacy in Your Tax Plans

What you may not want to do is leave behind unspent deferred comp to your kids in the form of deferred comp. When you leave behind deferred comp, you leave behind your unpaid federal income taxes. Under The SECURE Act of 2019, if your kids inherit your deferred comp as an Inherited IRA, they are required to liquidate the entire federally taxable account within 10 years of your passing. This means that they have to pay ordinary (earned) federal income taxes on all of your deferred comp that they inherit. If you fail to tax-plan now, you can push your kids into a higher federal income tax bracket.

There’s a lot to discuss, and there’s lots to consider.

Because of the complexities involved with federal income tax rules, various deferred comp plans and managing multiple retirement income streams, this part of retirement planning shouldn’t be left to chance.

If you’re not sure what steps to take, consider looking for a financial adviser who understands fire department deferred comp plans, fire department pensions, tax planning for firefighters in retirement, Roth conversions, Section 7702 of the Internal Revenue Code, and all the other specific challenges you face as a firefighter preparing for retirement.

Kim Franke-Folstad contributed to this article.