Like many workers nearing retirement, you give your employer your retirement date, you might even have a retirement party, and close that chapter in your life. If you’re a public safety personnel you’re afforded the opportunity to defer that retirement and enter into a DROP Program. The DROP Program is currently available for the Phoenix Fire and Police Departments and many other metropolitan cities throughout the country, including but not limited to San Diego Fire & Police Departments, Los Angeles City Fire Department, Denver Police & Fire Departments.
The DROP program stands for Deferred Retirement Option Plan. The retention program was designed to keep public-safety personnel working longer by making it lucrative to stay beyond their eligibility to retire. It was meant to keep experienced firefighters and police officers from retiring too early and putting a strain on the city to hire and train new sworn employees.
When you enter the DROP program, you cease to accumulate length of service years toward your pension. When you decide to separate from service, you can roll your DROP money into a tax-qualified account, take a lump sum distribution or do a combination of both.
You have actually “retired” and started drawing your pension. At this point your pension benefit is calculated using your credit service which is service time that the plan has received. You continue to work and are paid your salary and overtime, but you are also paid your pension every month which is set aside in a separate account. This is known as your DROP account.
While in DROP, the monthly pension payments the retiree would have been paid goes into a fund where they receive a guaranteed compounding rate of return from PSPRS, regardless of the trust’s financial performance.
You can stay in the program for up to 5 years, but then at that point you must retire officially. Whether or not to enter the drop is a unique decision and one which should be considered carefully based on one’s individual goals and future income needs.
Factors to consider:
- It’s Voluntary and Irrevocable Benefit
The DROP program is a voluntary and irrevocable benefit that you may elect into. Once you have signed into the program you are considered “retired” for all practical purposes. As such, your length of service is suspended, your final average salary is calculated, and you no longer accrue pension credits. At this point, you need to ask if they will be financially and emotionally ready to retire in 5 years? Something to plan ahead for is that the first pension check will not come until the month after separating services. If you don’t have enough money in checking/savings to pay for the next month’s bills, there are ways to pull a distribution from your other retirement accounts to get you to the end of the month. - When to Enter/Exit the DROP Program
- The first point to consider before exiting DROP relates to timing. When the DROP period ends of the 5th year typically, the employee must separate from service. It is important to time the exit from the DROP after the member turns age 50. Retiring any sooner may compromise the employee’s ability to access the DROP money without a 10% penalty. Per section 72(t)-10 of the internal revenue code, a firefighter can exit the DROP in the year he turns 50 and not be subject to a premature penalty. For example, say a chief is scheduled to exit a 5-year DROP in August of this year and anticipates a DROP balance of $350,000. Let’s assume he is presently age 49 but will turn 50 in December of this year. Per IRS guidelines, he can take a direct distribution from the DROP in any amount and not be subject to a 10% premature penalty. Now consider if he had chosen to exit DROP one year prior, in his fourth year of DROP. Under this circumstance, he would be age 48 at DROP exit and have limited flexibility in accessing DROP without a penalty. In this way, entering DROP is an irrevocable decision, so the entry date and exit date need to coincide with the firefighter turning age 50.
- In a similar vein to consider, is to separate from service in the first quarter of the year. By timing one’s retirement early in the year, the employee has the opportunity to maximize their retirement accounts by making another contribution for an additional year. An ideal way to accomplish this is by taking advantage of the catch-up provision within her 457(b) account. Most plans allow for a firefighter to roll unused sick time and vacation time to a 457 account. This tax deferral strategy is ideal for those who have accumulated sizeable unused balances. Rather than taking a check for these benefits, an employee has the opportunity to defer immediate taxation until a later date. Also, given the favorable distribution rules for 457 plans, a firefighter can request drawdowns right after separation from service occurs. For example, say a chief exits the DROP and has accumulated $18,500 in sick time and vacation time. He decides to have the city cut two checks: one to him for $5,000 to pay down debt, and another for $13,500 to his 457 provider. So long as he doesn’t exceed federal guidelines on maximum contributions to the plan for the year, he can redirect the larger second check to his 457 account and take distributions on his terms.
- The first point to consider before exiting DROP relates to timing. When the DROP period ends of the 5th year typically, the employee must separate from service. It is important to time the exit from the DROP after the member turns age 50. Retiring any sooner may compromise the employee’s ability to access the DROP money without a 10% penalty. Per section 72(t)-10 of the internal revenue code, a firefighter can exit the DROP in the year he turns 50 and not be subject to a premature penalty. For example, say a chief is scheduled to exit a 5-year DROP in August of this year and anticipates a DROP balance of $350,000. Let’s assume he is presently age 49 but will turn 50 in December of this year. Per IRS guidelines, he can take a direct distribution from the DROP in any amount and not be subject to a 10% premature penalty. Now consider if he had chosen to exit DROP one year prior, in his fourth year of DROP. Under this circumstance, he would be age 48 at DROP exit and have limited flexibility in accessing DROP without a penalty. In this way, entering DROP is an irrevocable decision, so the entry date and exit date need to coincide with the firefighter turning age 50.
- Contributions Stop
It is important to recognize that during the period between DROP-entry and DROP-exit most plans suspend a member’s contributions. So, if a plan member has been contributing 7% to the pension prior to DROP-entry, his paycheck will effectively increase by 7% once he enters DROP. This could be a great time to increase 457 contributions by a similar 7%, since the employee would not feel any difference in his take home pay. This would likely lead to a higher 457 plan balance at the end of the DROP period and be an important resource in retirement. In short, a plan member has every incentive to increase 457 contributions at DROP-entry. Additionally, it would be an ideal time for a financial review of the 457 allocation and consider rebalancing the portfolio to lower risk. - Right Payout Options
Choosing the correct pension payout for you and/or your spouse is an important strategy for retirement. The retirement benefit one chooses is a personal decision based on factors such as risk tolerance, investable assets, and whether one is single or married. The default retirement benefit in most plans is 10-year certain. This benefit is paid to you for life, but you or your beneficiary will receive at least 120 monthly benefit payments in any event. Keep in mind that the period certain begins once a member enters DROP, not at separation from service. For example, if a member is in DROP for 5 years, he has 5 years of period certain left when exiting DROP. - Accrued Sick and Vacation
Most DROP programs allow a member to roll unused sick time and vacation time to a 457 account. This tax deferral strategy is ideal for those who have accumulated sizeable balances. Rather than taking a check for these benefits, an employee has the opportunity to defer immediate taxation until a later date. Also, given the favorable distribution rules for 457 plans, a member can request drawdowns right after separation from service occurs. For example, say a chief enters the DROP and has accumulated $18,500 in sick time and vacation time. He decides to have the city cut two checks: one to him for $5,000 to pay down debt and another for $13,500 to his 457 account. So long as he doesn’t exceed federal guidelines on maximum contributions to the plan for the year, he can redirect the larger second check to his 457 account and take distributions on his terms. - Tax Consideration
This one issue that everyone loves to hate is unavoidable: the inevitable taxation of the DROP account. 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, the DROP at inception, are born with a twin…Uncle Sam! Just as your home is an asset, with the bank as your partner, 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. And DROP accounts are taxed at a significant rate. There are strategies where you can pay off your senior partner and remove them out of the picture, completely.
A final thing to consider at separation from service is cash flow needs. Different investment balances such as 457(b) money, 401(a) money, or DROP money, have different rules associated with withdrawals. Developing a financial plan to avoid early withdrawal penalties and to provide adequate income throughout your life are the cornerstone issues facing firefighters at retirement.
Deciding when to retire is an important decision and shouldn’t be taken lightly. There are a lot of moving parts and a lot of strategies to maneuver in order to acquire the best end result for your own personal situation. Being a public safety personnel affords you great retirement benefits but how you prepare and plan for retirement is all up to you taking control over your finances. Need some extra guidance? We want to help our public safety officers because you do so much for us, civilians! Contact us today for a 15-minute help session.
Photo by Matt Chesin on Unsplash
