Planning for a long, fulfilling life
Common Drop Questions
WHAT IS DROP?
DROP is an acronym that stands for deferred retirement option plan (or program) and is a type of “phased” retirement, as opposed to immediate retirement. It is a nuance of defined benefit plans or pensions, uniquely suited for government employees. Once an employee is eligible and chooses to “enter the DROP,” he then typically must separate from employment within the next 5 years. The participant “retires” once he enters the DROP, but actually separates from service at a later date. When he exits DROP, the retiree receives a portion of his pension as a lump sum, in exchange for a lower pension payment over his lifetime.
SHOULD I ENTER DROP?
There are many things to consider when answering this question.
For example, do you plan to promote soon or are you at the highest pay scale you plan to achieve? If you are promoting soon, you may want to wait to lock in the higher pension amount since your base salary will be higher. Will you want to leave the job at the end of your DROP (typically 5 years)? Some are not ready to make this commitment. Once you choose to enter the DROP program, you will not be able to work more than 5 years (typically), therefore you must be mentally prepared to retire. Many sworn employees have asked whether they ought to go in the DROP for the maximum number of years they're eligible. I will help you examine this issue and see what is the most prudent course of action.
WHAT DO I DO WITH THE DROP WHEN I LEAVE?
Since you cannot typically leave the money in the DROP account, you have basically 3 options:
- Take a lump sum distribution
- Roll the money to your deferred compensation plan (457), if the plan allows
- Roll the money to an IRA
Concerning the Lump Sum distribution, there will be a 20% mandatory withholding for taxes since the full distribution is taxable. This is important to consider since the DROP distributions tend to be large sums, potentially leading to a significant tax liability.
If you roll the distribution to your deferred comp plan or to an IRA, you can continue to defer taxes and invest the money. The decision to roll the balance to an IRA or to the deferred comp plan will largely be based on your age, the flexibility you need with your investments, and the type of investments most appropriate for your situation.
For additional information please review this brochure or contact us.
WHAT IS 72(t)-10?
This is a provision in the Internal Revenue Code from the Pension Protection Act of 2006.
72(t)-10 allows withdrawals from DROP at age 50 without a 10% penalty for qualified public safety employees. It is a one-time, "use it or lose it" option and is calendar-based, not age-based.
WHAT INVESTMENTS SHOULD I CHOOSE FOR MY IRA?
This is a question that is unique for each person.
Some individuals need to supplement their pension and invest in CD's, corporate bonds, or income-producing mutual funds. Others need growth-oriented investments like stocks since they have a greater risk-tolerance and longer time-frame. I will review your situation, create a customized plan, and implement a portfolio that fits your goals and risk tolerance.
WHAT ARE THE PROS AND CONS OF ENTERING DROP?
Whether or not to enter the DROP is a unique decision and one which should be considered carefully. For some, the decision is a foregone conclusion due to personal circumstances and an attractive plan design. For others, the decision is less obvious and involves a more thorough review of the trade-offs. The goal is to avoid the common pitfalls in the DROP-decision process and make informed choices that maximize the benefits offered within the pension plan and within the tax code.
CAN I HAVE A DIFFERENT BENEFICIARY FOR MY DROP THAN FOR MY PENSION?
Yes, pension benefits can be paid to a different named beneficiary than the one named for the DROP accumulation.
IS THERE AN IDEAL TIME TO ENTER DROP?
An important point to consider before entering the DROP relates to timing. Ideally, one would enter the DROP after a pay-raise from a promotion, or perhaps right after a COLA (cost of living adjustment) is announced. This would maximize the member’s pension and therefore lead to a higher DROP balance at separation. Most retirement systems have a maximum credited service limit, so it would be ideal to DROP once a member reaches this credited service ceiling. Also, it is important to time one’s exit from the DROP after the member reaches the age of 50. Retiring any sooner may compromise the employee’s ability to access the DROP money without a 10% penalty. Per section 72(t)-10 rules, a member can exit the DROP in the year they turn 50 and not be subject to a premature penalty.
WHEN I FINISH MY DROP TERM, CAN I LEAVE IT IN THE PLAN?
This depends on the rules governing the plan. Some plans allow participants to keep their DROP money in the plan, on a self-directed arrangement or on a discretionary basis via money managers within the pension. Most plans do not allow DROP money to stay in the plan.
AM I ELIGIBLE FOR A PRE-RETIREMENT DEATH BENEFIT ONCE I ENTER DROP?
No. Most plans do not allow for pre-retirement death benefits once you enter DROP. For this reason, it is prudent to review life insurance coverage prior to participating in DROP.
AT WHAT AGE MUST I BEGIN TAKING DISTRIBUTIONS?
Participants must begin receiving distributions from money left in DROP at age 72 regardless of their employment status. This IRS rule also applies to 457 money and to IRA money.