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IRS Issues Guidance on Payments Received During Phased Retirement

The IRS has issued guidance on whether distributions received during a phased retirement are amounts received as an annuity. The IRS issued the guidance in Notice 2016-39 and Revenue Procedure (Rev. Proc.) 2016-36 on June 10 in response to inquiries on the matter.

Notice 2016-39

The notice provides guidance regarding whether payments an employee receives from a qualified defined benefit plan during phased retirement are amounts received as an annuity under Internal Revenue Code Section 72. “Phased retirement” is understood in this case to be an arrangement under which a participant in a qualified DB plan begins receiving retirement plan distributions while he or she continues to work on a part-time basis.

The notice also provides guidance on the appropriate present value factors, as well as the amount of time, to be used in determining the basis recovery fraction of each payment received during phased retirement.

Notice 2016-39 says that payments received by an employee from a qualified retirement plan during phased retirement are not received as an annuity for purposes of Section 72 if all the following conditions apply:

1. The employee begins to receive a portion of his or her retirement benefits when he or she enters phased retirement and begins part-time employment, and will not begin receiving his or her entire plan benefits until he or she ceases employment and commences full retirement at an indeterminate future time. Even if a full retirement date is agreed upon at the start of phased retirement, the employee’s date of full retirement is indeterminate as long as it is possible that date could change.

2. The plan’s obligations to the employee are based in part on the employee’s continued part-time employment. This affects the duration of the payment of phased retirement benefits and the amount of additional retirement benefits the employee accrues during that time.

3. Under the plan terms, the employee cannot make an election regarding the form of the phased retirement benefit to be paid during phased retirement, but elects a distribution option at full retirement that applies to the employee’s entire retirement benefit, including the portion that commenced as phased retirement benefits.

The notice also says that to the extent the phased retirement payments received from a qualified DB plan during the period of part-time employment are amounts not received as an annuity, the rules of Section 72(e)(8) apply. Also, in order to determine the amount allocated to basis under Section 72(e)(8) and excludible from each phased retirement benefit payment, the basis recovery fraction determined in calculating the phased retiree’s accrued benefit must be applied to each payment.

Rev. Proc. 2016-36

The revenue procedure provides guidance regarding the application of Treas. Reg. §§1.72-2(b)(2) and 1.72-4(b)(1) to amounts to which Section 72 applies that are received from a non-qualified contract. It does not apply to amounts to which Section 72 applies that are received under a qualified plan as described in Section 72(e)(5)(D).The revenue procedure also says that Notice 2016-39 does not apply to amounts that are received from a non-qualified contract.

Rev. Proc. 2016-36 concludes that in applying the Section 72 regulations cited in the notice to a non-qualified contract, the possibility of further contributions to the contract or a subsequent election under the contract to receive the benefit payable under the contract in a different manner generally will not affect the determination of whether distributions are amounts received as an annuity.

Effective Dates

Notice 2016-39 and Rev. Proc. 2016-36 apply to taxable years beginning on or after Jan. 1, 2016. Taxpayers may, however, apply the notice and the revenue procedure to taxable years beginning before that date.

Both will appear in IRB 2016-26 dated June 27, 2016.