EP 4 – Washington State’s Deferred Compensation Plan Explained
Ethan Meikle discusses the details of the Deferred Compensation Plan (DCP) offered to Washington State employees. He clarifies that DCP falls under the 457 tax code and outlines contribution limits and flexibility of the plan. Insights are provided into traditional and Roth DCP plans, investment options including Target Date Funds, tax benefits, and strategies to decide between pre-tax or Roth tax routes.
He raises potential risks with Target Date Funds that aren’t unique to individual retirement plans, advocating for custom-built allocations. Ethan discusses the potential rise in taxes after 2025 and the need to prepare for future tax environments. He also hints at next week’s topic – Roth conversions into DCP and also highlights an online service offered to help with DCP investment advice strategies.
Outline:
00:05 Introduction to the Podcast
00:23 Understanding the Deferred Compensation Plan
00:57 Flexibility and Tax Options of Deferred Compensation Plan
01:30 Contribution Limitations and Investment Choices
02:29 Understanding Target Date Funds
03:05 The Risks of Targeted Funds
04:04 Custom Built Allocations for Retirement
04:27 Tax Benefits of Deferred Compensation Plans
04:41 Choosing Between Pre-Tax and Roth Deferred Comp
05:47 Understanding Future Tax Implications
06:46 The Benefits of Roth DCP
07:50 Roth Conversions and Future Episodes
08:09 Conclusion and Additional Resources
Transcript
Welcome to the Washington State Retirement Planning Podcast. I’m your host, Ethan Meikle. In this podcast, we specialize in helping Washington State employees get a better understanding of how their complicated retirement benefits work so you can hopefully retire earlier, pay less in taxes, enjoy more free time with your loved ones.
Today’s episode is all about the Deferred Compensation Plan offered by Washington State. So if you’re not sure what that is or how it works, this is a great episode for you to listen to.
So Washington State offers something called a Deferred Compensation Plan, they abbreviate as DCP.
This actually falls under the 457 tax code. So you ever heard of getting a 457 plan? The Deferred Compensation Plan is the exact same thing. So when you get one of these plans, which you’re able to get one as long as you’re a state employee, they’re offered pretty much everywhere, they’re open enrollment.
So you can get one at any time you want to. You can start one of these up anytime you want to, you’re allowed to increase the contributions anytime you want to, decrease contributions, start and stop them. So they’re fully flexible plans and they are completely optional ways to contribute for your retirement.
So when you contribute into them, you now have the option to choose how you want to be taxed on it. Do you want to pay taxes now or do you want to pay taxes later? And that’s, another term for that is if you’re using the traditional DCP plan or using the brand new Roth DCP plan that just started October 1st of 2023.
So regardless of which one you use, they still have the same contribution limitations. So the most you contribute into one of these plans as of 2024 is 23, 500. If you’re under the age of 50, it can go up to 30, 500 if you’re over the age of 50. Now, that is the cap for how much you can do total, so it doesn’t matter if you do that all to the pre tax side, all to the raw three split 50 50, you just can’t go over that 30, 000 threshold.
Now, if you have another 457 plan you’re contributing to, they have the same limitations, so you gotta be careful there. Most people don’t have that, though. If you have a 403b plan, those contribution limits, they are the same as this, but because this is a separate tax code, it’s a 403b, not a 457. They are completely separate, so you could contribute the max to your Deferred Compensation Plan and still contribute the max to your 403b plan.
So, with Deferred Compensation Plans, you’re able to choose how you want the money to be invested. Now, by default, you’re going to put into something called a Target Date Fund. Now, a Target Date Fund, all it is, is a basket of funds. That kind of predicts when you’re going to retire. So they automatically default it to the closest when you’re going to turn age 65.
And they go in 5 year increments. So you’re going to see something like target date or target strategy 2030, 2035, 2050, 2055, so on and so forth. Now, the idea behind it is as you get closer to retirement, they’re supposed to automatically adjust the risk tolerance. They’re adding more bonds for you as you get closer to retirement.
So it’s, in the way they claim it, a little bit safer route to go. Now the problem with targeted funds is they’re not unique to you. Everybody has their own retirement plans, lineup, risk tolerance levels, and so forth. So it’s really hard to give mass recommendations out there because it’s not specific to you.
Especially working with state employees. If you’re not going to go to H 65, Chances are the targeted fund that’s saying that you’re going to retire at 65 is going to have too much risk because it’s assuming you’re working longer than you actually are. So that’s one reason why targeted funds aren’t that great of a thing to have overall.
They’re also constantly in the media getting sued because oftentimes they don’t take on enough risk when you’re young and they leave you with too much risk when you’re older. So in 2020 when the market tanked, people were shocked to see that their strategy fund, the 2015 and 2020 strategy fund, when it’s supposed to be.
What they thought was safe because that’s the year they’re retiring in took an 18 percent dive in a few months. So just because it’s a targeted fund doesn’t mean that there’s no risk involved into it. In fact, there’s probably a lot more risk than you really understand that’s there. So typically I recommend that you have custom built allocations specifically for you, because only you are going to know your own level of risk tolerance, when you plan to retire, and things of that nature.
Now, if you have no idea where to begin with getting custom built allocations, Recommendations on the Deferred Compensation Plan. We actually built a service that does exactly that. I’ll link them in the show notes for you guys.
Now we’ll take a step back and talk about the tax benefits of using one of these tax deferred plans. Because one of the common questions that are going to start coming up now is, should I do the pre tax deferred comp? Should I do the Roth Deferred Comp, or should I do both?
And the answer is always going to be, it depends. Because everyone’s tax situations, retirement income plans, they’re all going to be different. So it’s hard for me to kind of gauge which one is going to be better for someone off of an email or a short conversation on the phone. Typically what I like to do is look at someone’s tax returns, and then I like to look at, , their pension numbers to see, you know, what is our future retirement income going to be at.
If you fall off the cliff and your income is going to be a lot lower, Then maybe the pre tax drop might be the way to go. However, I can say this, that most people I talk to, because the employees in Washington have a pension and a Social Security, they typically have less of a dive than most Americans.
So because they have a guaranteed floor of income that’s higher, and all of it is taxable, you typically, even though you’re going to make less in retirement, most people don’t make so much less that they’re changing multiple brackets. You might bump down one bracket and that’s usually it. Oftentimes we see people not move brackets at all and they’re kind of surprised when we show them those numbers.
So it’s important that you look at your own situation, get a gauge of what income is in the future, and where do you think it’s going to put you tax wise. Now the current tax code we have is set to expire at the end of 2025, so you only have two more years left. of the current tax environment. So when it expires, or if it expires, I Should say, we’re expecting all taxes to go up.
Basically, the law says we revert back to the way things were in 2017 and then they adjust for inflation. So the way things back were in 2017 was taxes were higher across the board. The 12 percent bracket was 15, the 22 was 25, and so on and so forth. Everything goes up. The second thing that a lot of people aren’t going to see coming is the standard deduction got doubled in the current tax law.
So most couples now are writing off close to 30, 000 a year, just free and clear. That gets cut in half. So going forward, if the tax were to revert the way it was, you now get half the deduction that you’re used to these past few years, which means more income is now subject to taxes, aka a higher tax bill for you.
So there’s a lot of things to look at when deciding, you know, should I go the pre tax route or the Roth route
all that being said though the Roth route typically works Good for people in the sense that it gives them another tax free of bucket to dip into in retirement
Some of the worst situations in retirement is you go in there, you have your pension, you’ve got your Social Security checks, your taxable income sources, and all you have is pre taxed money in the Deferred Compensation Plan, 403b, or whatnot, and that’s your only income source, anyway you turn you’re getting taxed on it.
So when you have money in a Roth DCP, you have the opportunity to dip into a tax free account, an account you already took care of the taxes on, that you don’t have to worry about having to get rid of the tax bill. So, if in retirement, taxes are crazy high one year, and you’re like, hey, I don’t want to pay more taxes, but I need money on my account.
If you pull it out of the Roth account, you pay no tax on that money because you paid it initially. You paid it when taxes are back at this 24 percent rate, not at whatever the future rates may be. So in a way, doing a Roth DCP or Roth anything is a form of tax insurance. You’re buying the bullet now, you’re locking in the rates now because we feel like it’s lower than it will be in the future.
One other strategy that opened up with this deferred compensation plan is the ability to do. Roth conversions. Now, next week, I got a whole episode on how to do Roth conversions into the DCP. What does that even mean? How does it work and how it can potentially save you six figures. So be sure to come back next week for that episode.
And before I sign off, remember that in the show notes will be links to get onto our website for more free resources for you guys, as well as the link to sign up for the Deferred Compensation Investment Advice System. So if you need help figuring out what do I invest in and more importantly, when should I make changes to it?
That’s all there in that service. So go ahead and check that out. Link will be in the show notes. Alright, that’s a wrap for today. I’ll catch you guys all next week. Remember that your future depends on what you do today.