Meet DROP’s silent partner: Uncle Sam
Deciding whether or not to participate in DROP (Deferred Retirement Option Plan) is a unique decision, largely based on an individual’s goals and future income needs.
For the vast majority of firefighters, entering DROP is the best of both worlds: a large lump sum at retirement and a steady pension check throughout retirement. One issue however is unavoidable: the inevitable taxation of the DROP money.
As soon as the decision to enter DROP is made and pension benefits start to accumulate in the DROP account, a silent partner patiently waits during the DROP period, usually up to 3 to 5 years, and eagerly anticipates his future share in the form of taxes.
In short, DROP’s at inception are born with an evil twin……….Uncle Sam! Just as your home is an asset with a bank as partner (for most people), your DROP account is an asset with the government as partner. However, in the latter relationship, the government is effectively the “senior” partner since they dictate what tax rates the money will be subjected to.
Wouldn’t it be nice if you could convert your DROP account from “always-taxed” to “never-taxed” and remove Uncle Sam as Senior Partner? Furthermore, wouldn’t it be nice to pay off your senior partner at historically low tax rates? Well the good news is that you can, via a Roth IRA.
Starting January 1st, new tax rules will remove income limits that previously prevented some people from converting a traditional IRA to a Roth. Just about anyone will be able to convert a traditional IRA to a Roth IRA.
An example will help illustrate how the strategy works: Mike is a firefighter who is age 54 with 25 years of service and plans on exiting DROP with $250,000 this year. Additionally, he has accumulated $100k in his deferred comp plan and will work as a fire inspector after “retiring”. Mike decides to roll the DROP account to a traditional IRA. This transfer is a non-taxable event. Then, through the help of his CPA and financial planner, he converts $100k from the traditional IRA to a Roth IRA. This conversion is a taxable event, but if done in 2010, the tax burden can be spread out over the years 2011 and 2012 (or paid fully in 2010). Also, this tax diversification strategy works best if the taxes are paid from a source other than the IRA, perhaps a checking or savings account for example.
Furthermore, the conversion does not have to be all or nothing. Once the Roth IRA is funded, Mike will enjoy tax-free growth in the account, eliminating the uncertainty over future tax rates. For many individuals, the decision isn’t whether to convert money to a Roth IRA, but rather, how much money to convert to a Roth IRA.
Given the ballooning national debt of this country, taxes at all levels are expected to rise in coming years. Indeed, many feel that Congress will let prior tax rate cuts lapse after 2010, particularly if the economy is on a much better footing. Given this reality, along with relatively low tax rates, this could be a great opportunity to set the stage for a tax-free retirement.
Consider contacting me to discuss your specific situation and I will design a comprehensive, customized plan for you and your family.
Rick Palmer is a Certified Financial Planner™ and Senior Investment Management Consultant with Morgan Keegan & Co., Inc. He specializes in managing DROP distributions for firefighters and emergency services personnel. He can be reached at: (800) 564-3589 and www.gotdropusa.com
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This information is for illustrative and discussion purposes only. Morgan Keegan does not provide legal or tax advice. You need to contact your legal and tax advisors for additional information and advice before making any investment decisions. Morgan Keegan & Company, Inc. Members New York Stock Exchange, SIPC Securities are not bank guaranteed, not FDIC insured, and may lose value.