If you are an active duty or retired FDNY member you probably are aware you have various choices on accounts you can use to save for retirement. Depending on your employment tier these can include the pension excess accounts, Traditional or Roth 457, Traditional or Roth 401(k), IRA’s and the group annuity. When it comes to the 457, and/or the 401(k) if you want to save greater than the 457 limits, you have the option to have your contributions go into the Traditional option, the Roth option, or a combination of the two. Each of these accounts have their unique characteristics that sets them apart from one another.
Traditional versus Roth
What is the difference between the Traditional and Roth retirement accounts? The Traditional option allows for you to save on taxes now while you are putting money aside via lowering your taxable income and deferring that taxation until you start taking withdrawals from the account. The Roth option is designed so that you continue to pay taxes on the income you fund into the Roth account now but have tax-free income in retirement.
Examples … Let’s say an FDNY member saved $10k per year for 20 years into their 457 plan and after 20 years they have a balance of $500,000.
Traditional Qualified Account
In the Traditional example the firefighter would have deferred income of $10k per year and perhaps saved $2-$3k per year in income taxes depending on their family scenario and tax rates. When they start taking withdrawals on the 457 the money taken out will be fully taxable in that year. For example a $25,000 withdrawal will lead to $25,000 of additional taxable income in that year. One important note – a benefit to note for FDNY members who retire and stay in New York state and take withdrawals once they reach 59 ½ years old or older, you may qualify for a pension and annuity exclusion of up to $20,000 from New York State taxable income.
Roth Qualified Account
In the Roth example the firefighter would have paid taxes on their full income, not deferring the $10k per year and as a result perhaps paid $2-3k more per year in taxes than someone who used the Traditional plan. However the account will be available to access in the future tax-free. In the example of someone taking a $25,000 withdrawal, this money would be income tax-free if rules are met including reaching age 59 ½ and the initial Roth contribution being made at least five taxable years ago. Roth accounts can also be an advantageous way to pass assets on to the next generation as they will be able to access the inherited value tax-free, versus having it be taxable income to them as it would in a Traditional account.
Is One Better Than the Other?
Most people, including FDNY members, will save in their 457 or 401(k) via the Traditional option so that they can generate tax savings now. The idea is save on taxes while you are working and your income is higher, and pay taxes on the money when you retire and your income is lower. However, in the case of an FDNY member their income may end up being higher in retirement based on their pension benefits, potential additional income if they continue to work post FDNY retirement, withdrawals and RMD’s from retirement accounts, and ultimately social security benefits.
The decision on whether to fund retirement benefits via the Traditional or Roth 457 and/or 401(k) is a personal choice for each firefighter and depends on their thoughts on what their income might look like in retirement, what tax rates could be in the future, and their preferences on saving on taxes now or saving on taxes in retirement. One option that could be worth utilizing given the uncertainty of what income will be in retirement, what tax rates will be in retirement, and whether or not someone will retire on a taxable traditional pension or a potentially predominantly tax-free disability pension, is to do a combination of the two so that you can generate some tax savings today, but also have access to some funds tax-free in retirement. Additionally given various withdrawal rules for both types of accounts, it could be advantageous to hold money in the Traditional account or both types of accounts.
One more option to consider is Roth conversion. If a firefighter has already retired and just saved in the Traditional 457, or if they want to leave the option open for having funds in a Roth account in the future, you could look at doing a Roth conversion in retirement. In this scenario, you would convert money from a Traditional retirement account to a Roth and realize the income and associated taxes in that year but then have funds in a Roth account going forward. This strategy may be particularly attractive to firefighters who retire with a disability pension and who have a low level of taxable income, as they can convert some of their Traditional retirement account(s) over to a Roth account each year and potentially remain in a lower tax bracket.
We would suggest that you talk to a trusted tax advisor and financial advisor about these decisions as while they may seem like small ones today, could amount to a significant difference over time. Our team at Client Focused Advisors would be to happy to discuss these choices further with you if you would like.