For members of the Florida Retirement System (FRS) participating in the Deferred Retirement Option Program (DROP), receiving a lump sum distribution upon retirement can feel like an opportunity to tackle large financial goals—such as paying off a mortgage. While eliminating a mortgage may sound appealing, there are important tax and retirement planning implications to consider before using DROP funds this way.
This post explores why retirees should approach this decision carefully and what factors might affect whether it's the appropriate move for their overall retirement plan.
DROP accumulations are considered deferred salary and are fully taxable when distributed. If you take the entire balance as a lump sum to pay off a mortgage, that amount is added to your taxable income for the year.
Why this matters:
A large distribution could push you into a higher federal income tax bracket.
You may owe more in taxes than expected, particularly if withholding was not adjusted adequately.
Depending on your total income, this could also affect taxation on Social Security benefits or trigger higher Medicare premiums (IRMAA).
If your DROP balance large and you take it all as a lump sum, that full amount may be added to your taxable income. Combined with your pension or other income sources, this could significantly increase your tax liability for the year.
By using your DROP money to pay off a mortgage in one lump sum, you’re giving up the potential for that money to continue working for you—either through interest, dividends, or growth if invested in a retirement account such as an IRA.
Consider:
Once the funds are used to pay off debt, they are no longer available to generate potential income or provide flexibility.
Even modest growth in an IRA or conservative portfolio over time could contribute to your future financial stability.
Liquidity is reduced—unlike a mortgage, which typically has manageable monthly payments, home equity is not easily accessible without refinancing or selling the home.
Rather than using all of your DROP money to pay off debt immediately, some retirees choose to:
Roll over DROP funds into an IRA to spread out taxable distributions over time.
Establish a retirement income plan that includes a mix of cash flow sources (pension, DROP, 457, etc.).
Maintain flexibility for healthcare expenses, emergencies, or other long-term needs.
This approach can help minimize tax exposure and retain options for future spending or investing.
Age and time horizon: If you retire early, you may need your DROP funds to last for a longer period. Using them all at once may limit long-term flexibility.
Mortgage interest rate: If your interest rate is low, it may make more sense to keep the mortgage and use DROP funds more strategically.
Risk tolerance and goals: For some, being debt-free is a priority. However, it's important to weigh that preference against the long-term financial trade-offs.
Paying off a mortgage with DROP money may seem like a straightforward way to reduce monthly expenses, but the decision can carry lasting tax and financial consequences. It’s important to evaluate how a lump sum withdrawal affects your taxable income, your long-term investment potential, and your overall retirement income strategy.
If you’re unsure about which way to use your DROP funds, it may be helpful to work with a financial professional who understands FRS retirement benefits and the tax implications associated with them.