Don’t be Phased by Annuity Treatment: Taxation of Distributions During Phased Retirement

by Eversheds Sutherland (US) LLP

On June 10, the Internal Revenue Service (IRS) issued Notice 2016-39 in response to inquiries regarding the appropriate tax treatment under section 72 of the Internal Revenue Code (the Code) for payments received by an employee from a qualified defined benefit plan during phased retirement. For purposes of the guidance, phased retirement is an arrangement under which a participant in a qualified defined benefit plan commences the distribution of a portion of his or her retirement benefits from the plan while continuing to work on a part-time basis. The IRS simultaneously issued companion Rev. Proc. 2016-36, providing a different analysis for non-qualified annuity contracts issued outside of retirement plans.

Generally, Code section 72 requires that a taxpayer’s gross income includes any amount received as an annuity under an annuity contract, less certain amounts that are treated as “investment in the contract,” which are allocated to each annuity payment. Investment in the contract represents recovery of the taxpayer’s basis and is calculated based upon the aggregate amount of premiums or other consideration the taxpayer paid for the contract, less any amount received under the contract before the annuity starting date (to the extent that amounts received were excludable from income). Simplified rules apply for determining allocation of investment in the contract in the case of qualified retirement plans, in which case investment in the contract is divided evenly among the expected number of monthly payments. 

Plan sponsors raised questions regarding taxation of payments from a defined benefit plan during phased retirement because, under Code section 72, amounts are only “received as an annuity,” and therefore subject to the basis recovery rules described above, if (i) the amounts are received on or after the annuity starting date, (ii) the amounts are payable in periodic installments at regular intervals over a period of more than one full year from the annuity starting date, and (iii) subject to certain exceptions, the total of the amounts payable are determinable at the annuity starting date either directly from the terms of the contract or indirectly by the use of either mortality tables or compound interest computations. For this purpose, “annuity starting date” means the first day of the first period for which the first periodic payment is made under an annuity contract, provided that obligations under the contract have been fixed as of that date.

These requirements often are not satisfied in the context of phased retirement, including in the following situations: 

  • In some cases, the participant will have a second commencement event upon full retirement, raising the question of the appropriate annuity starting date;
  • The phased retirement program may not fix the employee’s date of full retirement, and even if it does, the retiree likely has the option to unilaterally elect full retirement; 
  • The participant may accrue additional plan benefits during the period of phased retirement;
  • The participant may have the option to elect a different form of benefits after completing the phased retirement program; and
  • The defined benefit plan may be amended to modify the formula under which the participant accrues benefits during the term of the participant’s involvement in the phased retirement program.

IRS Notice 2016-39 explains that amounts received from a defined benefit plan during phased retirement will not be treated as “amounts received as an annuity” if (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 terminating employment and commencing full retirement at an indeterminate future time (for this purpose, even if a full retirement date is agreed upon at the time that phased retirement is commenced, the employee’s date of full retirement is indeterminate if it has the possibility of changing); (2) the plan’s obligations to the employee are based in part on the employee’s continued part-time employment; and (3) under the plan terms, the employee does not have an election for the form of 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. 

As a result, retirement payments received from qualified defined benefit plans during phased retirement will be subject to the rules of Code section 78(e)(8). Under these rules, the amount of each payment that is excludable from the participant’s gross income is the portion that is determined by multiplying the amount of the payment by the ratio of the employee’s investment in the contract (e.g., basis) to the total value of the employee’s accrued benefit (the basis recovery fraction). The present value factors for calculating lump sum distributions, if any, should be used for determining the total value of the employee’s accrued benefit. The basis recovery fraction may be fixed at the time phased retirement payments commence without a requirement to recalculate the ratio for each subsequent payment. Upon the participant’s full retirement, the participant’s investment in the contract as of the annuity starting date will take into account investment in the contract recovered during phased retirement. 

The new guidance does not apply to amounts received from non-qualified plans or contracts, which are subject to rules explained in Revenue Procedure 2016-36. Apparently to defend the section 72 rules specific to the taxation of non-qualified annuities, the IRS concluded that the possibility of further contributions to a non-qualified contract or a subsequent election to receive the benefit payable under the contract in a different manner generally will not affect the characterization of payments as amounts received or not received as an annuity. 

Both the Notice and the Revenue Procedure are effective as of the 2016 tax year, but can be relied on for previous tax years.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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