How Deferred Retirement Option Plans (DROPs) Work

Deferred retirement option plans (DROPs) are of benefit to both employees and employers. In exchange for continuing to work past your eligible retirement age, an employer will set aside annual lump sum payments into an interest-bearing account. Upon retirement, the money that has grown in this account will be paid to you, on top of the rest of your accrued pension earnings.

If you have more questions or want some help getting your retirement plans together, consider talking with a financial advisor.

What Are Deferred Retirement Option Plans (DROPs)?

A deferred retirement option plan, or DROP, is a retirement program for an employee who would otherwise be eligible to retire but who opts to keep working. Instead of continuing to add new years of service, thereby increasing the employee’s pension benefit amount, the employer begins placing lump sums into an interest-bearing account on an annual basis.

When the employee finally retires, they will receive the full value of this account, in addition to their established pension benefits. This arrangement allows the employee to earn additional retirement benefits, while the employer gets to retain the employee’s services (without further increasing that employee’s pension payout).

Most DROPs are for public sector employees, like police officers, firefighters and teachers. This is both because these plans were first introduced by government employers and because few private companies offer pension plans anymore.

More specifically, a DROP would apply to someone who:

Has a defined benefits retirement plan from their employer (typically in the form of a fixed pension)
Is of retirement age, but chooses to continue working

How Are DROP Benefits Calculated?

Because DROP plans are offered by so many different employers, the specifics of each plan can vary. Here’s a quick rundown of some of the most important factors to look out for when it comes to the calculation of DROP benefits:

Participation length: Most employers won’t let you participate in a DROP indefinitely. Instead, they typically offer a window of time called a “participation limit.” Some plans suggest employees participate for a maximum of seven years, but four years is common.
Payment amount and interest: Each employer will specify how much they’ll pay into your DROP account, how it will gain interest and how much that interest will be. DROP payments often equal the normal retirement benefits you would have received during this period, but that is not necessarily the case.
Health, worker’s compensation, disability and other benefits: Sometimes a DROP may classify you as “formally retired” but still working. Under this formula, many previous benefits may no longer apply. So if you’re considering a DROP, be sure to determine the status of your other benefits. These usually end once you officially retire.
Dispersal and taxes: All DROPs will pay you the full value of the account once you fully retire. However, your employer may have different models for how you receive the money. Some may pay the funds as a lump sum, while others may offer to pay you over time. The method can have an effect on your tax situation when you retire.

Although DROP plans might seem complex, once you have the above information, the benefit calculation is fairly simple to figure out.

As an example, suppose you’re ready to retire after working for 30 years as a police officer. Your average salary on the job was $55,000, and your DROP plan comes with a four-year participation limit and a 2% accrual rate.

To calculate what you could earn through your DROP, you’d multiply your average salary ($55,000) by your 2% accrual rate. Then, multiply that figure by the 30 years you worked. That should come out to $33,000. Spread that out over four years, and your DROP account could be worth as much as $132,000.

How Defined Benefit Plans and DROPs Differ

A defined benefit plan is what most people think of as a pension plan. Basically, it is a guarantee from an employer to make payments to the employee for the duration of their retirement.

A typical defined benefit plan calculates benefits based in part on how many years you’ve worked for the employer. Each year you work there, your benefits go up. At retirement age, you begin collecting those benefits.

Without modification, you can continue to grow your pension plan benefits by working past your retirement age. So, if you retire at age 70 instead of 66 or 67, you’d collect more in benefits. This is similar to how Social Security works.

A DROP cuts off this continued pension growth. Under a DROP, if you continue to work past retirement age, your employer won’t continue adding to your benefits calculation. Instead, they will take a sum of money and place it into an interest-bearing account. The amount of that lump sum and your account’s structure will differ based on the specific plan.

The employer’s contributions to this account will continue for as long as you keep working and qualify for the DROP. Once you fully retire, your benefits plan will begin payouts as normal. You will also receive the full value of the DROP account, including all of the interest it accrued while you were working.

Tax Treatment and Rollover Options for DROP Payouts

A deferred retirement option plan typically applies to someone who has a defined benefits retirement plan from their employer (usually in the form of a fixed pension).

DROP distributions are generally treated as taxable income when they are paid out, whether as a lump sum or through installment payments. The timing and structure of the payout can affect a retiree’s marginal tax rate in the year funds they receive the funds. Large lump-sum distributions may increase taxable income substantially in a single year, while installment options may spread tax liability over multiple years.

Some DROP plans allow participants to roll all or part of their payout into a tax-deferred account, such as a traditional IRA or an eligible employer-sponsored plan. When permitted, a rollover can defer income taxes until withdrawals begin. Not all plans offer this option, however, and rollover eligibility often depends on plan rules, payout timing and IRS rollover requirements.

DROP payouts may also interact with other tax considerations, including taxation of Social Security benefits and Medicare premium surcharges. Higher income in the year of distribution can increase the portion of Social Security benefits subject to tax or trigger higher Medicare Part B and Part D premiums in later years.

Because payout structure, rollover availability and tax effects vary by plan and by personal circumstances, understanding how a DROP distribution fits alongside pensions, retirement accounts and Social Security income can clarify the overall financial impact of participating in a DROP.

Pros and Cons of DROP Plans

While DROPs offer the opportunity to enhance your financial security, they may not be ideal for every person or situation. There are advantages as well as disadvantages to DROPs that you’ll want to consider before enrolling.

Pros	Cons
Lump sum payout at retirement One of the most attractive features of a DROP is the ability to accumulate a large lump sum payout, which provides an additional pool of money beyond the monthly pension benefit.	Interest rate risk The interest or growth in a DROP account may be variable depending on the terms of the plan. If the interest rate is lower than expected, or is tied to market performance, the DROP account may not meet your expectations.
Continued salary, plus retirement savings While enrolled in a DROP, employees continue receiving their full salary while also “banking” pension payments in the DROP account, boosting overall retirement savings.	Inflexibility once enrolled Once you enter a DROP, the terms are often locked in, meaning you must retire at the end of the DROP period, even if your circumstances change.
Interest/investment growth The pension payments deposited into the DROP account typically earn interest or returns, increasing the value of the lump sum available upon retirement.	Tax implications The lump sum payout from a DROP is typically subject to income tax when withdrawn. Depending on the size of the payout, this could push you into a higher tax bracket, leading to a larger tax bill.
Guaranteed pension income Once enrolled in a DROP, your pension payments are “locked in” at the rate you would have received upon initial retirement eligibility, giving you some degree of certainty regarding future pension income.	Penalties for early withdrawal While the funds in the DROP account are available upon retirement, withdrawing them before retirement (or too early) may trigger taxes or penalties.
No impact on regular pension benefits Once the DROP period is over, employees still receive their regular monthly pension benefits, which had been frozen at the time of entry into the DROP. (The DROP simply adds the bonus of the accumulated lump sum.)	Frozen pension benefits When you enter a DROP, your pension is “frozen” based on your salary and years of service at that time. If you receive raises or promotions during the DROP period, they won’t increase your pension payout.
Encourages extended employment For employers, DROP plans can be a way to retain experienced employees who might otherwise retire.	Potential early retirement impact If you join the DROP before you reach full retirement age, you may face reduced pension payments because you’re locking in a lower benefit.

How to Decide If a DROP Is Right for You

If you’re already eligible for full retirement but are healthy, willing to continue working and not in urgent need of pension income, a DROP may offer a way to boost your retirement savings. The program allows you to lock in your pension benefit while still collecting a salary.

When evaluating the option, you’ll want to consider how the DROP account grows during your participation. Some plans offer a fixed interest rate, while others may tie growth to market performance or use a lower crediting rate. Compare this growth potential to alternative uses of your time and income, such as retiring and investing your pension payments on your own. In some cases, the interest earned in a DROP account may be less than what you could earn elsewhere. That said, the added predictability and low risk of a DROP account may be worth it depending on your risk tolerance.

Be sure to review any limitations of the program as well. Most DROP plans freeze your pension calculation based on your salary and service at the time of entry, so raises or additional years of service will not increase your pension benefit. Additionally, if you receive a lump sum payout, it is usually subject to income taxes and may affect your tax bracket in retirement.

You’ll also consider whether the required DROP end date aligns with when you actually want to stop working. Reviewing your full retirement picture, including pensions, IRAs, 401(k)s and Social Security, can help you determine if a DROP is a strategic fit.

Bottom Line

Be sure to weigh the pros and cons of a deferred retirement option plan.

Like anything related to retirement, it’s important to weigh the pros and cons of all your options prior to making any major decisions. Deferred retirement option plans offer perks in exchange for working a little longer. But just because there’s money on the table doesn’t mean that remaining in the workforce is the right choice for you. Consider the specifics of the account, its tax implications and your holistic retirement income setup to make a decision.

Tips for Your Retirement Plans

It can be daunting to build a retirement plan on your own. That’s why some choose to work with a financial advisor to help with the investing and financial planning. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Although most Americans would find it nearly impossible to live off of Social Security alone, it can be a great supplement to your existing retirement assets. Curious about what you can expect to receive in Social Security? Check out SmartAsset’s Social Security calculator.