DROP Taxation
A tax comparison of two options with the Deferred Retirement Option Plan (DROP).
The Deferred Retirement Option Plan (DROP) is the lump-sum retirement benefit many firefighters elect to receive at the end of their career. Let’s look at some options for leveraging this benefit.
Stephen and Brian McCaffrey both sign-up for the 3-year DROP with 32 years on the job. In Indianapolis, that equates to a $62K annual pension and lump-sum DROP benefit of $188K in 2022.
Stephen decides to use the DROP to pay off his mortgage.
Brian decides to roll the DROP to an Individual Retirement Account (Fun fact: IRA technically stands for Individual Retirement Arrangement).
Assuming Stephen and Brian each file their taxes jointly with their spouses, their normal household marginal tax rate is 12% - not bad!
To pay for his house, Stephen adds the DROP funds to his ordinary income for a gross income of $250K. He pays approximately $42K in taxes that year at a new marginal tax rate of 24%.
Conversely, Brian realizes his greatest expense in retirement isn’t his mortgage, it’s taxes! He chooses to pay $0 in taxes when he rolls the DROP into his IRA. He can pull income from his IRA throughout retirement paying a top tax rate of only 12% (half the rate Stephen paid!). Brian can fill up the 12% tax bracket and pay off his house over a couple years or perform a Roth conversion so the converted funds are never taxed again!
What's a Roth conversion anyways?
A Roth conversion involves transferring funds from a pre-tax retirement account into a Roth IRA (post-tax retirement account).
The account holder must pay taxes in the year they convert funds, but when the funds are in the Roth IRA, they can grow tax-free forever.
In this example, Brian could convert $47,450 to his Roth IRA at a tax rate of only 12%!
Here's the rough math for 2022:
$62,000 pension income
- $25,900 standard deduction
= $36,100 taxable income
*It's important to note, later in retirement, social security income and required minimum distributions will add to taxable income.
$83,550 is the top of 12% bracket in 2022
- $36,100 taxable income
= $47,450 available at a tax rate of 12%
*Printable version below
