Government employees, such as teachers, firefighters, police, and others, often consider working after their eligible retirement age when presented with a DROPs offer. A DROP program is a tax-advantaged retirement plan that provides employer monies in exchange for the employee continuing to work past retirement. In a DROP program, the employer sets aside an annual-lump payment into an interest-bearing account that the employee accesses later when they retire.
DROP programs are an additional retirement savings program for employees that want to continue working but have reached their pension payout limit. Despite working more years, they can't increase their pension amount because they have maxed out their years of service pension accumulation. Here are other things to know about DROPs:
- Employers offer DROPs to entice retirement-age employees to continue working.
- DROPs are used alongside defined benefits retirement plans that are typically fixed pensions.
- DROPs have specific participation lengths, such as four to seven years.
- The DROP's yearly payment amount and interest rate are set in the DROP plan documents.
- DROPs allow employees to accumulate more tax-deferred retirement monies for retirement.
The DROP compensation amount is based on the employee's average annual salary, years of service, the accrual rate (interest), and the length of time the employee participates in the plan. Before deciding to continue working and participate in a DROP program, employees should consider these pros and cons:
- The employee can add to their retirement savings.
- The DROP plan may have a higher accrual rate than their pension plan.
- If not rolled into another retirement savings strategy, the payout may push the employee into a higher tax bracket since it's taxed as ordinary income.
- If the employee continues working, there may be a short window to enroll in the DROP plan.
Once an employee fully retires, their pension benefits plan will begin, and they will also receive the total value of the DROP account, including all the interest it accrued. If the employee doesn't want to pay taxes on the DROP payout now, they can transfer the value and pay taxes later when using these strategies:
- Transfer the DROP monies into an annuity.
- Transfer the DROP monies into an IRA.
There may be other options to consider, depending on your situation. A financial professional can help you understand your options if you plan to participate in a DROP program or are nearing retirement and have DROP monies.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
An Annuity is a financial product sold by financial institutions that is designed to accept and grow funds from an individual and then, upon annuitization, pay out a stream of payments to the individual at a later point in time. Annuities are primarily used as a means of securing a steady cash flow for an individual during their retirement years.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
This article was prepared by Fresh Finance.
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