Highlights of Income Tax Consequences of Deferring a Pension Into DROP

You may be eligible to defer your pension into the Deferred Retirement Option Program (hereinafter “DROP”). If so, there are federal income tax consequences that you should consider before making an election to defer into DROP. The Dallas Police and Fire Pension System (“System”) cannot provide financial or legal advice to you or tailor these highlights to your particular situation. However, these highlights will discuss some of the income tax consequences that result from deferral into DROP by pensioners in various circumstances. You should consult a tax or financial advisor who has expertise in the federal income tax treatment of annuities and distributions from qualified pension plans before electing to defer your pension into DROP.

Pension payments, under tax-qualified plans such as the Combined Pension Plan, are taxed when you receive them in much the same way as your salary was taxed before retirement. However, the part of the pension payments considered to be a return of the Pensioner’s own after-tax Member contributions is eventually recoverable tax-free. Any pension payments that you elect to defer into DROP will not be taxed until they are paid to you out of your DROP account. This can be attractive to you if you are working and in a higher tax bracket now, but expect to be in a lower tax bracket when you receive your DROP distribution. Unfortunately, the deferring of your pension into DROP can cause you to pay more federal income taxes in certain cases.

If you elect to defer your pension into DROP and amounts are withheld for any reason, such as to pay premiums on your health insurance, those withheld will be subject to tax. These amounts are treated as annuity payments because they will be paid by the System in substantially level monthly payments.

More importantly, the Internal Revenue Service imposes an additional early distribution tax to certain payments received by a Pensioner before age 59½. The early distribution tax is 10% of the taxable pension received. This additional tax does not apply if you qualify for one or both of two exceptions to this tax law: 1) You terminate Active Service with the Police Department or Fire Department in or after the calendar year you attain age 55, and/or 2) you terminate Active Service before the year you attain age 55, but receive only your monthly pension payments until after you attained age 59½.

The eligibility for the second exception to the 10% early distribution tax may be adversely affected by an election to defer your pension into DROP or take distributions from your DROP account. If you attained age 55 in or before the year you left Active Service, an election to defer your pension into DROP will not subject your benefits to an early distribution tax. Furthermore, if your pension is not yet in pay status, that is, you have elected to defer your pension into DROP, you will not owe a 10% early distribution tax on any pension payments held in your DROP account.

On the other hand, if you leave Active Service before the year you attain age 55 and you receive payment of your monthly benefits for a period of less than five years before age 59½, you will owe the early distribution tax plus interest thereon, on the taxable pension benefits you have received before age 59½. This will be the case if you initially defer receipt of your benefit and later begin to receive payment or if you start receiving monthly benefits when you leave Active Service and later elect to defer your benefit, and the period you actually receive payment before age 59½ is fewer than five years.

Similarly, if you revoke your DROP deferral election before you attain age 59½, you may owe early distribution taxes plus interest on any taxable deductions that have been made during the deferral period and on the taxable pension and DROP payments received in the year of the election.

Of course, the tax treatment of your pension is only one of the considerations you should take into account before electing to defer your pension into DROP. However, it is a very important economic consideration and you may want to time any election you make so as to minimize adverse tax treatment.