By Allen Giese, CLU®, ChFC®, ChSNC®

As an FRS Special Risk participant, you have an amazing retirement benefit that is the envy of everyone who works outside the public sector. I’m talking about the Deferred Retirement Option Program, or DROP. The DROP allows you to continue working while receiving your salary and benefits, but with your pension payments being deposited into a special, interest-bearing, tax-deferred account. And what makes this program even more incredible is that the use of your DROP funds is completely unrestricted. You can do whatever you want with it … as long as it’s legal, I guess! So in this video, we’re going to dive deep into some ideas that maybe you hadn’t considered for how you can use your DROP funds in a way that reflects you and your goals.

The world’s your oyster when it comes to your DROP, and what you do with it is completely up to you. But when you break down all the options, I think you’ll find they fall into one of these four categories. You can either:

Spend it and use it to buy something you’ve been wanting;
Use it to supplement your retirement and increase your financial security;
Pass it on, creating a lasting legacy for your next generation; or,
Give it away and support a charity or cause that matters to you.

Now, you can do any of those things or combine them in any way that works best for you. So, let’s take a close look at each one.

Buy Something … Awesome!

It’s your opportunity to go a little crazy here. What’s that thing you’ve always wanted? An RV to tour the country in? How about a yearlong cruise around the world? Maybe it’s a sailing yacht with more adventure in it than you can imagine. Whatever it is for you, this might be your chance to make it a reality.

With the enhancements made to the DROP program for FRS Special Risk participants in 2023, it means there’s a significant pot of gold waiting for you at the end of your DROP, especially if you go the full eight years. But before you drop your DROP money on that RV, world cruise, or yacht, there’s a few things you need to know so you won’t be surprised when the time comes. The first of which, I’m sure you’re already aware, is that when you take your DROP money out, it’s all taxable income to you and taxed at ordinary income tax rates. So let me give you an example of what that tax hit might look like.

Let’s assume we’re talking about a recent retiree with a pension of $8,000 a month or $96,000 a year, with no other income like Social Security yet or anything else. We’ll also assume that we’re only using the standard deduction and filing as a single person. Using 2025 tax rates, the income tax this person would be expected to pay before taking anything out of their DROP account would be $12,734. Not too bad—an overall effective rate of something like 15.7%.

Now let’s take a look at it if this retiree takes $250,000 out of their DROP account and buys that dream machine or whatever that bucket list item is. In this case, the retiree would be expected to pay $85,397, or an additional $72,663, in income tax. That DROP money he or she took out has an effective tax rate on it of just over 29%, nearly double the rate as before because it was taken all at once. That’s what is meant when you hear we have a progressive tax rate: The more you take, the higher the tax rate. Is it still worth it? Only you can decide, but it’s probably better to know this stuff before you take that big distribution than after.

One other thought concerning tax rates on big distributions: It can also cause you to pay more for your Medicare premium if you are of Medicare age. In this scenario, it would have increased Medicare premiums for this retiree from $185 a month to $591.90 a month for at least a year. Again, I’d want to know that before I took that distribution.

The last point I’ll make on this is to make sure you are taking enough out of your DROP to cover both the big purchase plus the taxes on that big purchase plus the taxes on the additional amount you’re taking out to cover the taxes! In the example we just ran through, that means to end up with the $250,000 to make the purchase, you’ll need to take out an additional $86,000 the following year to cover the taxes next April, for a total of $336,000, or you won’t have enough to cover your tax bill next April.

Again, only you can decide: Was it worth it to, at the end of the day, pay $336,000 for that $250,000 thing?

Supplement Retirement

Another option you have is to use your DROP money as a way to supplement your ongoing retirement income. Maybe step up your overall lifestyle a bit. That means investing it in something and taking a monthly or annual stream on income from it that’ll make your retirement just that much more secure. But be careful here. This is where it gets a bit more complicated and where we see some big mistakes!

One of those mistakes we see retirees make here, in their effort to secure a reliable stream of income, is buying an annuity from an insurance agent or broker that’s heavy in expenses, has surrender charges that penalize you if you decide it’s no longer right for you, pays that advisor a big commission for selling it to you, and really has little hope of delivering a competitive return. I’m not saying don’t ever put your money into an annuity. In the right situation, an annuity might be the right answer. What I am saying is, if your insurance agent is pitching you an annuity, before you buy it, get a second opinion on what some of your other options are from someone who’s not getting paid to sell annuities. And if an annuity is right for your situation, there are annuities out there that have no commissions, have no surrender charges, so you can change your mind and have much lower annual fees than the broker-sold annuities we see being offered by most insurance agents. Your broker won’t show you those annuities simply because they don’t get paid if you buy them. Be smart and be thorough. This is often a decision you can’t go back and fix without doing some serious harm to your DROP.

And as long as we’re talking about annuities, another option you need to be aware of that you can explore deeper on the myFRS website is to transfer your DROP money into an annuity that FRS is recommending through MetLife Insurance Company. Just in case you’re not familiar with annuities, what a fixed income annuity like the Metlife annuity on the FRS site offers you is a guaranteed lifetime stream of income, backed only by MetLife’s ability to pay. It’s a lot like your pension.

As you can probably tell at this point, I’m not too fond of annuities. As I mentioned, I find they are often loaded with excessive fees, have high commissions that ultimately you pay for, and often have harsh surrender charges, which penalizes you heavily if you need your funds or just change your mind. And in the case of an annuity that has entered the “payout” phase, as in the case of the MetLife annuity with FRS, if you want the lifetime income, the decision is irrevocable. No changes are allowed once you start. In other words, just check it out carefully and make sure it’s the right thing for you.

So what are some of the options besides annuities? The choices you have here are many, but what we find helpful in guiding us to the right choice for you is seeking choices that are highly diversified, have historical evidence of delivering competitive long-term returns, and are low in cost. The bar, as it were, is set by highly diversified, globally invested investment accounts of thousands of stocks and bonds well-managed at a low cost. We have a hard time finding a better choice with a better promise than that.

Let’s go a little deeper and look into how you do that with your DROP. To begin with, when you retire, you can keep your FRS DROP money with FRS by moving it into the FRS Investment Plan. There, you’ll have access to the various investment options, including the thousands of additional investment choices available on the Self-Directed Option account.

We could probably do a whole separate video just on the potential pitfalls here, but I’ll summarize our thoughts on this by simply saying, I wouldn’t recommend this as an option unless you really know what you are doing. I’d say that historically, the chances of you having a good investment experience are probably low, and this is not the time and place to learn. It may very well be worth working with someone who knows the platform well, knows and understands Modern Portfolio Theory and, where, in capital markets, returns come from. The cost of making a mistake here is just too big. Again, I wouldn’t go it alone unless you really know what you’re doing.

Similar to keeping the account at FRS is, you could move it over to a traditional IRA at the brokerage of your choosing. The big mistake we see here is doing this too soon—before you’re 59 ½—thus putting the funds in jeopardy of an excise tax of 10% if you withdraw money prior to that age. Easy mistake to avoid if you just don’t move it into an IRA until you’re at least 59 ½ years old.

Create a Legacy

Assuming your pension income, Social Security income, and any other income you have is more than enough to do everything you want to do and you don’t really need to tap into any of your DROP money, a choice we often see FRS participants make is to preserve the money for their next generation, creating a legacy for their kids.

This has a lot of similarities to the previous few minutes of our discussion here about investing your DROP—of course, without the annuity as an option. But the difference here, or the big concern, is more around taxes when the goal becomes legacy planning. Thats because the DROP is in a tax-deferred plan, and when you die, in most cases when it goes to your beneficiary who isn’t a spouse, that person is obligated to pay the taxes on the account, and they are required under current tax laws to take the money out of the account—thus triggering the taxes—within a 10-year period.

So stop and think about that for a second. When does this typically occur? If I die in my 80s, my kids are in their 50s or maybe 60s, and that’s often the case. They’re in what are most likely their highest-earning years, paying more taxes than they’ve ever paid before, and all my money from my DROP, having grown for a whole bunch of years, comes crashing down on them, increasing and pushing them into higher and higher tax brackets. Meaning, that money that I’d saved for them is getting taxed at progressively higher rates, and boy, was Uncle Sam glad I did that!

On one hand, you can say, “So what? My kids still get a whole pile of money.” But if you want to increase the net amount your kids get after taxes, you might want to consider paying the taxes now, at least on some of it, at your lower rates while the money is still relatively small compared to what it will be later. So, for our clients where legacy goals are high on their list of priorities, setting up a plan to convert their DROP money to much more tax-favorable Roth IRA plans becomes all that much more important.

And finally, worth a short discussion here, where legacy is a goal, would be the creative use of life insurance to potentially expand your wealth one day when you die. Life insurance can be particularly effective if, one, you’re healthy and can qualify for good rates and, two, you’re young enough still where the rates make sense. Additionally, if you have a special needs son or daughter that you’re responsible for, this may become an effective part of your planning, and your DROP money can be used to secure that special needs person after you’re gone.

But planning here also becomes complicated, and further complicated by the way life insurance is sold and the high commissions it pays—as much as 50 to 100 percent of the first-year premium you pay. We see big mistakes made here by well-intentioned but perhaps underexperienced or misinformed life insurance agents. Make sure you’re working with someone on this part of your planning that isn’t compensated by the size of the life insurance premium you’ll be paying and is a competent financial planner looking at the whole picture.

Charitable Giving

For some people, making some corner of the world better off for them having been here is a big goal. We often find that an underlying reason is that charity they want to support made a difference in their life or the life of a family member or somehow just struck a chord with them. We’ve seen and had clients who have donated significant amounts to humane societies, charities supporting health, human rights, mental health charities, and religious charities. Again, the world’s your oyster, and if giving your wealth away is right for you, then there are good ways to do it and, well, ways that maybe aren’t quite as effective or don’t take advantage of the tax code as well.

Clearly, working with a planner here should make a difference. Competent, skilled planners have knowledge and understanding of the use of charitable trusts you can set up, how to work effectively with strategies around qualified charitable distributions from your IRA, and how to integrate your charitable planning with your own estate planning to maximize the effect of each.

If what I’m talking about describes you, then, one, I admire you and commend you for wanting to make the world a better place, but, two, I want to urge you to not go it alone. Make sure you’re working with someone competent and experienced.

So there’s a lot you can do with your DROP, and I hope you found this video helpful. We’re here for you, at Northstar Financial Planners, to help you achieve whatever your goals are. We’ve been working with FRS Special Risk participants for about 20 years now, and if you feel you might benefit from sitting down for a discussion about your situation, we’d love to hear from you.

Thanks for watching! Thanks for what you do for the rest of us, and stay safe out there.