The Deferred Retirement Option Program (DROP), available under the Florida Retirement System (FRS) Pension Plan, allows a member to retire while continuing employment for up to 60 months. While in the DROP, the member’s retirement benefits accumulate in the FRS Trust Fund and earn monthly interest equivalent to an annual stated rate. In most cases, the DROP participants must cease employment after the maximum 60 months in the DROP. Once the FRS employment ends, the participant can select one of three payout options.
– Option 1 – A lump sum payout that goes directly to the retiree
– Option 2 – 100% direct rollover into an IRA or another qualified account
– Option 3 – Partial cash payout to retiree with the remaining balance rolled over into an IRA or another qualified account
When choosing between the three options, it is important to consider the tax implications. If participants choose a lump sum, the FRS will send the DROP payment directly to the participant, less 20% withheld for federal income taxes. If the participant is younger than 59 ½ (or age 50 or 55 depending on the retiree service class), the DROP payout is considered an “early distribution” and may be subject to the 10% early distribution penalty. Depending on the dollar amount of the lump sum, that payout could bump the participant into a higher tax bracket, which could result in the participant paying significantly more in taxes than if he/she had only withdrawn a portion of the account that year. One of the biggest mistakes that participants can make is to take the lump sum payout and use that money to pay their mortgage or car loan, which can result in disastrous tax consequences.
If a participant chooses a 100% direct rollover, the FRS will send the DROP payment directly to the selected eligible account. Generally, once the payment is rolled over into an eligible account, participants must wait until age 59 ½ to take a withdrawal or the withdrawal may be subject to the 10% penalty. Once participants reach age 70 ½, they must start taking required minimum distributions (RMDs). If a participant chooses to roll the DROP payment into a traditional IRA, flexibility is one of the biggest advantages. IRAs offer flexible investment options and participants have a greater ability to choose when and how much will be withdrawn from the account. With proper planning, income taxes on distributions can be minimized. In an IRA, the account will continue to grow tax-deferred, allowing the assets to have greater compounding growth than if the participant took the lump sum and invested it into a taxable account. Participants should be cautious about purchasing insurance or annuity products with their DROP money. These products can come with high fees and may have harmful tax consequences.
If a participant has a need for a portion of the DROP account up front but would like to take advantage of the tax-deferred growth of a rollover, the partial lump sum is an option to consider. If the participant chooses a partial payout, the FRS will send a portion of the total DROP balance as a lump sum directly to the retiree, less the 20% federal withholding, and they will send the remaining balance as a direct rollover to the selected eligible account. The lump sum portion of this payout will also be subject to the 10% of the early distribution penalty depending on the participant’s age and services class.
The details of the FRS DROP can be very complicated. The information provided above is general and subject to many exceptions. DROP participants should consult with a financial planning specialist that is experienced with the FRS DROP to assist you in determining which option is best for your specific circumstances.
Peter C. Golotko, CPA/PFS, MBA is President and CEO of CPS Investment Advisors. Leighann Davis, Portfolio Analyst at CPS Investment Advisors, is a contributing author of this article.