FAQS – HOW AFTER–TAX CONTRIBUTIONS AFFECT YOUR DROP FUNDS
DROP BASIS RECOVERY
FREQUENTLY ASKED QUESTIONS
If you made after-tax pension contributions, your DROP funds may include after-tax “basis”. “Basis recovery” is the process by which your after-tax employee pension contributions are returned to you, free of taxes, as part of your pension benefits.
I’ve heard that if I’m exiting DROP after January 1, 2014, that I will get a refund or rebate. Is this true?
The amount due to you from DROP has not changed. However, the taxability of your DROP account will be determined differently, depending upon whether or not you’ve made after-tax employee pension contributions. You may be able to receive part of your DROP distribution tax-free.
How do I know if I’ve made after-tax employee pension contributions?
You may have made after-tax contributions for any of the following reasons:
From 7/1/82 – 12/20/96, mandatory pension contributions were collected after-tax.
- Elective purchases of service credit made by contract or lump sum payments are collected after-tax. (Trustee-to-trustee transfers from Deferred Compensation are pre-tax.)
- The voluntary 2% “opt-in” pension contributions certain members elected in order to vest future retiree medical subsidy increases are collected after-tax. (Note: This does not apply to Tier 6 members.)
How is the non-taxable portion of my DROP account determined?
If you made after-tax pension contributions, your DROP funds may include after-tax “basis”. “Basis recovery” is the process by which your after-tax employee pension contributions are returned to you, free of taxes, as part of your pension benefits.
If you are exiting DROP, the Internal Revenue Code includes a provision that allows you to recover a portion of your eligible after-tax contributions using an accelerated basis recovery method. This method allows you to take a lump sum distribution of any eligible after-tax DROP funds, rather than recovering it in payments over your lifetime through the Simplified Method. If you exit DROP on or after January 1, 2014, you will be subject to the following basis recovery method:
- Recover pre-1987 after-tax contributions entirely from the lump sum DROP distribution.
- Have any post-1986 after-tax contributions allocated pro-rata between the lump sum DROP distribution and your ongoing monthly pension annuity. Any after-tax funds not recovered from the DROP lump sum, will be recovered through the Simplified Method from the monthly pension annuity.
What is the Simplified Method?
It is the formula that the Internal Revenue Code requires us to use to determine the amount of your ongoing monthly pension benefit that is taxable vs. the amount that is tax-free. You can read about this formula in IRS Publication 575. The tax-free portion is based on the amount of your unrecovered after-tax contributions at retirement and your age (plus your spouse’s/domestic partner’s age, if applicable), when you exit DROP and begin to receive pension benefits.
The formula determines the amount of your pension that will not be taxed and the length of the time for that exclusion. By subtracting the tax-free amount from your gross pension for a fixed number of months, your already taxed contributions will be recovered. Cost-of-living pension increases will not change or have any effect on the tax-free amount since the calculation is based upon your remaining after-tax contributions at retirement.
How will I know how much of my DROP distribution will be non-taxable?
When you receive your DROP distribution election forms, you will be provided with your distribution options, the breakdown of your after-tax contributions, the amount that may be recovered tax-free from your DROP distribution and how much you will recover on an ongoing basis from your monthly pension benefit tax-free.
What if I exited DROP prior to January 1, 2014?
This change was implemented January 1 to coincide with the beginning of the tax reporting year. If you exited DROP prior to January 1, 2014, no after-tax basis was allocated to your DROP account. You are recovering all of your after-tax contributions from your ongoing monthly pension annuity, using the Simplified Method.
LAFPP’s tax counsel is working with the IRS to confirm the proper tax treatment of all benefits.
For any questions, please contact the DROP/Service Pensions Section at (213) 978-4575.