If you’re nearing retirement age but not quite ready to leave the workforce behind, a deferred retirement option plan (DROP) may be the answer. These plans were first introduced in the 1980s by public-sector employers; today they’re offered to firefighters, police officers, and other types of civil servants. DROPs offer dual benefits to both employers and eligible employees. Keep reading to learn more about the finer points of these plans and why they may be a good option for workers who are interested in a phased retirement.

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 may seem complex at first glance, but they’re not overly complicated. Here’s how they work. An employee who would otherwise be eligible to retire and start drawing down benefits from an employer’s defined-benefit plan keeps working instead. Rather than having those additional years of service included in future benefit calculations, the employer places a lump sum of money into a separate account for each year the employee remains on the job. This account earns interest as long as you’re still reporting to work. Once you actually retire, the money held in that account is paid to you, interest included, on top of whatever money you’ve accumulated in your pension plan over the course of your career.

The way the funds are paid out to you depends on how the plan is structured. For example, eligible members of Florida’s Retirement System (FRS) pension plan have the option of taking their payout as a lump sum, a rollover into their State of Florida Deferred Compensation account, or a combination of a lump sum and rollover.

It’s important to note that DROPs may impose a defined window of participation in which you can enroll and earn benefits, which can vary based on the program. State employees in Louisiana, for instance, have a 60-day window to enroll once they reach their first eligible retirement date. Once they’re in the plan, they can participate for a maximum of 36 months. In Florida, by comparison, employees can stay in the plan for up to five years. 

Only firefighters, police officers, teachers, and other types of 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 the past 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 the workforce stable is a definite advantage.

Pros

  • Employers: Keep employees working longer, especially in fields such as law enforcement and education.

  • Employees: Continue adding to retirement savings, especially 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.

There are a couple of reasons why DROPs may be viewed favorably by workers. If, for example, you’ve already maxed out your lifetime benefits payable from a defined-benefit plan, you could continue adding to your nest egg through a DROP. The rate of accrual that you get from a deferred retirement option plan may also be better than what the defined-benefit plan offers.

One thing to which workers should pay attention is how those benefits are paid out once their participation period in the plan ends. If you’re taking a lump sum, for example, those benefits would be taxed as ordinary income, which could possibly push you into a higher tax bracket. Rolling over the funds to another qualified plan could allow you to sidestep a bigger tax bill. You need to weigh all the options before making a move. 

The Bottom Line

Deferred retirement option plans can be a valuable resource for public-sector employees who are hoping to bolster their savings before retiring. If you’re eligible to take part in one of these plans, be sure to read over the details carefully to ensure that you’re making the most of it. Most important, plan ahead for how a DROP lump-sum payment or rollover could affect your tax situation.