Got DROP?

What is a Deferred Retirement Option Plan (DROP)?

DROP is a provision in public sector plans which allows you to have your monthly retirement benefit credited to a separate account while you continue to work. Originating in the state of Louisiana, the DROP provision has allowed many employees the opportunity to leave their jobs with potentially large lump-sum accumulations.

Drop Characteristics
  • Keeps more experienced people on the job
  • Reduces or eliminates cost of training and recruiting new people
  • Lump Sum Liquidity Event + Pension= "Best of Both Worlds"

 

(Journal of Financial Planning 2001)

Drop Benefits
  • Participation not mandatory
  • Irrevocable decision causing years-of-service to be suspended ie. Last 5 years don't count toward pension credits
  • Separate account- considered part of pension plan
  • When separation of service occurs, employee has option to take DROP balance

Drop's PartnerDeciding whether or not to participate in DROP (Deferred Retirement Option Plan) is a unique decision, largely based on an individual’s goals and future income needs. For the vast majority of employees, entering DROP is the best of both worlds: a large lump sum at retirement and a steady pension check throughout retirement. One issue however is unavoidable: the inevitable taxation of the DROP money. As soon as the decision to enter DROP is made and pension benefits start to accumulate in the DROP account, a partner patiently waits during the DROP period and eagerly anticipates his future share in the form of taxes. In short, DROP’s at inception are born with a twin……….Uncle Sam! Just as your home is an asset with a bank as partner (for most people), your DROP account is an asset with the government as partner. However, in the latter relationship, the government is effectively the senior partner since they dictate what tax rates the money will be subjected to. Wouldn’t it be nice to pay off your senior partner at historically low tax rates, convert your DROP account to a tax-free account, and remove Uncle Sam as partner? Well the good news is that you can, via a two step process to a Roth IRA. New tax rules removed income limits that previously prevented some people from converting a traditional IRA to a Roth. Just about anyone is now able to convert a traditional IRA to a Roth IRA. An example will help illustrate how the strategy works: Mike is a firefighter who is age 54 with 25 years of service and plans on exiting DROP with $250,000 this year. Additionally, he has accumulated $100k in his deferred comp plan and will work as a fire inspector after “retiring”. Mike decides to roll the DROP account to a traditional IRA. This transfer is a non-taxable event. Then, through the help of his CPA and financial planner, he converts $100k from the traditional IRA to a Roth IRA. This conversion is a taxable event. Also, this tax diversification strategy works best if the taxes are paid from a source other than the IRA, perhaps a checking or savings account for example. Furthermore, the conversion does not have to be all or nothing. Once the Roth IRA is funded, Mike can enjoy tax-free growth in the account as long as he has held the account for 5 years and is age 59 1/2 or older, eliminating the uncertainty over future tax rates. Given the ballooning national debt of this country, taxes at all levels are expected to rise in coming years. Given this reality, along with relatively low tax rates, this could be a great opportunity to set the stage for retirement.

 

 

Raymond James does not provide legal or tax advice. We recommend you consult your legal and/or tax advisor before making investment decisions.