Deferred Retirement Option Plans (DROPs): Everything You Need to Know

Is a DROP right for you? Deciding whether it’s worth it to keep working

Reviewed by Marguerita Cheng

If you’re nearing retirement age but not quite ready to leave the workforce, a deferred retirement option plan (DROP) may be the answer. Introduced in the 1980s by public sector employers, DROPs are offered to some firefighters, police officers, and other civil servants who are eligible to draw from their employer pension plans.

A DROP is an incentive for older workers to delay retiring. They get a sum of cash for every year they work beyond their official retirement age. Meanwhile, they’re on the job instead of drawing pensions.

Key Takeaways

• Employers like DROPs because they allow valued employees to keep working longer.
• Employees like DROPs because they allow them to add to their retirement funds after their defined-benefit plans have been maxed out.
• Workers should pay special attention to how the funds in their DROP are paid out to avoid excessive taxation.

How Deferred Retirement Option Plans Work

DROPs are designed for older workers who are eligible to retire if they choose.

If they retire, these workers would be eligible to begin drawing benefits from their employers’ defined-benefit pension plan. Now relatively rare among private employers, many public service employers still provide these plans, which commit the employer to paying a set income for the life of the retiree.

If they opt to stay on the job, they may be eligible for a DROP.

An employee who accepts the DROP retains pension plan eligibility and has reached the maximum amount payable from the plan. However, the employer will deposit a lump sum into a separate interest-bearing account for each year the employee remains on the job. When the employee retires, the money in the account and the earned interest are paid to the new retiree.

DROP Rules Vary

The precise terms vary. For example, eligible members of Florida’s Retirement System (FRS) pension plan have the option of taking the payout as a lump sum, a rollover into their State of Florida Deferred Compensation account, or a combination of a lump sum and rollover.

DROPs may impose a defined window of participation during which an employee can earn benefits. This varies too. In Florida, employees can stay in the plan for up to eight years.

Important

Some firefighters, police officers, teachers, and other civil servants are eligible for DROP plans.

Calculating Your DROP Benefits

The amount of compensation you’re able to receive through a DROP is based on your average annual salary, how many years of service you have under your belt, the accrual rate, and the length of time you participate in the plan. Here’s an example of how your benefits can add up.

Let’s say you’re 55 years old and have been a teacher for 25 years, earning an average annual salary of $40,000. Your state retirement system offers a DROP with an annual accrual rate of 2.5% and a participation limit of four years. If you multiply that $40,000 by the 2.5% accrual rate, then multiply that by 25 years, you’d get $25,000. If you were to work the full four years past your retirement date, that’s $100,000 you’d have in your DROP.

DROP Pros and Cons

The number one benefit of a DROP for employers is that it allows them to keep employees working longer. In fields such as law enforcement and education, being able to keep a stable and experienced workforce is a definite advantage.

Pros

• Employers: Keep experienced employees working later.

• Employees: Add to retirement savings after lifetime pension benefits have maxed out.

• Employees: May have a higher rate of accrual than a defined-benefit plan.

Cons

• Employees: Some plans have a short enrollment window; it’s easy to miss the period when you can enroll.

• Employees: Taking a lump sum could push you into a higher tax bracket that year.

For employees who have maxed out their lifetime benefits from a defined-benefit plan, this is a chance to continue adding to a retirement nest egg.

However, they need to consider how those benefits are paid out. If it’s a lump sum, the benefits would be taxed as ordinary income. Rolling over the funds to another qualified plan or individual retirement account (IRA) is one way to sidestep a bigger tax bill.  

What Is a DROP Savings Plan?

A DROP is a voluntary addition to a defined benefit pension plan.

An employee who has reached the usual retirement age and has maxed out the pension benefit payment due after retiring can opt to delay retiring for a few years. The employer who offers a DROP addition deposits an annual sum of money in an account for the employee. Upon retiring, the employee gets the expected pension benefit plus the DROP cash payout.

The employer retains an experienced worker and delays paying out a lifetime pension benefit. The employee gets a cash bonus for staying on the job.

A DROP is available only to some employees who are eligible for defined benefit pension plans. Most are public service employees.

Who Is Eligible for a DROP Payment?

The DROP program is available to employees who are active members of pension plans offered to public service employees by some state and local government systems.

Employees are eligible if they could retire and begin drawing a pension based on their age or years of service. Instead, they opt to stay on the job. In return, they get a lump sum benefit in addition to the pension later, when they retire.

How Much Is the DROP Payment?

Like the pension benefit, an employee’s DROP payment is based on the person’s salary and length of service. It works like a deferred salary payment and is deposited to accrue interest until the employee retires.

The Bottom Line

Deferred retirement option plans can be a valuable resource for public-sector employees who want to delay retirement and bolster their savings. If you’re eligible, be sure to read over the details carefully to ensure that you’re making the most of it. Most importantly, consider how a DROP lump-sum payment could affect your tax bill, and plan accordingly.

Read the original article on Investopedia.