IRS Addresses Calculation of Taxable Portion of Phased Retirement Payments

(Parker Tax Publishing June 2016)

Recent IRS guidance explains how to calculate the taxable portion of phased retirement payments received from a qualified defined benefit plan, and the tax treatment of payments received under a non-qualified contract. Notice 2016-39; Rev. Proc. 2016-36.

Phased retirement programs allow certain employees who already meet specific age and service requirements to elect to transition into retirement by continuing to work on a part-time basis while receiving distributions from a defined benefit plan before the annuity starting date. The employees continue to earn additional retirement benefits and make after-tax contributions. Such programs are designed to enhance the mentoring and training of the employees who will be filling the positions or taking on the duties of more experienced retiring employees.

For tax return preparers, one of the main issues with respect to phased retirement payments is the calculation of the taxable amount that must be reported on a taxpayer's return. Until the issuance of Notice 2016-39 and Rev. Proc. 2016-36, it was unclear whether the amounts received under phased retirement programs were taxed under Code Sec. 72 as amounts received as an annuity or as amounts not received as an annuity. The IRS has now clarified that the tax treatment of such payments depends on whether the payments are received under a qualified plan or a non-qualified contract and whether specific conditions are met.

Tax Treatment of Payments under Code Section 72

In general, Code Sec. 72 provides that distributions from an annuity, endowment, or life insurance contract are includible in gross income except to the extent the distribution is a non-taxable return of investment. For purposes of determining the extent to which a distribution is a non-taxable return of investment, Code Sec. 72 distinguishes between an "amount received as an annuity" and an "amount not received as an annuity." Code Sec. 72 also differentiates between amounts received from qualified plans and amounts received from non-qualified contracts. The treatment of amounts that are not received as an annuity differs substantially depending on whether the amount is received from a qualified plan or a non-qualified contract.

Generally, amounts distributed to any distributee by any qualified plan are taxable under Code Sec. 72 to the distributee in the year distributed. Under Code Sec. 72(b)(1), gross income does not include that part of any amount received under an annuity contract which bears the same ratio to that amount as the investment in the contract (as of the annuity starting date) bears to the expected return under the contract. For this purpose, the investment in the contract as of the annuity starting date is (1) the aggregate amount of premiums or other consideration paid for the contract, minus (2) the aggregate amount received under the contract before the annuity starting date to the extent that the amount was excludible from gross income. The annuity starting date in the case of any contract is the first day of the first period for which an amount is received as an annuity under the contract. Code Sec. 72(b), however, does not apply in the case of any amount received as an annuity under a qualified employer retirement plan.

In the case of any amount received as an annuity under a qualified employer retirement plan, the investment in the contract is recovered under the simplified method of Code Sec. 72(d)(1). Under this method, gross income excludes the portion of a monthly annuity that does not exceed the amount obtained by dividing (1) the investment in the contract (as of the annuity starting date) by (2) the number of anticipated payments determined under the table in Code Sec. 72(d)(1)(B)(iii).

Code Sec. 72(e) provides rules that apply to any amount which is received under an annuity, endowment, or life insurance contract and is treated as not received as an annuity. If an amount to which Code Sec. 72(e) applies is received before the annuity starting date, it is included in gross income to the extent allocable to income on the contract and is excluded from gross income to the extent allocable to the investment in the contract. For amounts received from a qualified retirement plan that is not treated as received as an annuity, the amount allocated to the investment in the contract is the portion of the distribution which bears the same ratio to the amount of the distribution as the investment in the contract bears to the vested account balance. This determination is made at the time of the distribution or at a time prescribed by the IRS.

Phased Retirement Payments Not Treated as an Annuity under Code Section 72

In Notice 2016-39, the IRS provides that payments received by an employee from a qualified retirement plan during phased retirement are not treated as received as an annuity for purposes of Code Sec. 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 begins full retirement at an indeterminate future time (for this purpose, even if a full retirement date is agreed upon at the beginning 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 (which affects both the duration of the payment of phased retirement benefits and the amount of additional retirement benefits the employee accrues during that period of part-time employment); and

(3) under the plan terms, the employee does not have an election as to 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.

If these conditions are met, the amount excludible from an employee's gross income is a portion of each payment, determined by multiplying the amount of the payment by the ratio of the employee's investment in the contract (i.e., the employee's basis) to the total value of the employee's accrued benefit (i.e., the basis recovery fraction). If a plan has present value factors that are used for purposes of calculating lump sum distributions (including partial lump sum distributions), those factors (rather than factors specified in Reg. Sec. 20.2031-7) are used in calculating the value of the accrued benefit for purposes of determining the excludible portion of a payment.

The basis recovery fraction is applied to each payment received. The fraction is generally determined as of the date of the payment to which it applies. According to the IRS, incremental changes to the basis recovery fraction resulting from any after-tax contributions made during the period of continued part-time employment, as well as changes in the present value of accrued benefits during this period, will typically have no more than a minimal effect on the amount excludible from the employee's phased retirement payments. As a result, no recalculation of the basis recovery fraction is necessary in such situations. Thus, the basis recovery fraction applicable to a series of phased retirement payments is fixed at the time those payments begin.

When an employee subsequently begins full retirement, the employee's investment in the contract as of the annuity starting date will take into account the investment in the contract recovered during the period of part-time employment and any additional employee contributions made during that period. Such payments will be treated as amounts received as an annuity under Code Sec. 72.

Tax Treatment of Amounts Received from a Non-Qualified Contract

In Rev. Proc. 2016-36, the IRS provides that Notice 2016-39 does not apply to amounts received from a non-qualified contract. According to the IRS, in applying Reg. Sec. 1.72-2(b)(2) (relating to the definition of "amounts received as an annuity") and Reg. Sec. 1.72-4(b)(1) (relating to an annuity starting date) 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 has no effect on the determination of whether payments received under the contract are amounts received as an annuity.

Observation: Notice 2016-39 has a detailed example of basis recovery calculations for phased retirement and full retirement payments.

For a discussion of the tax treatment of amounts received as an annuity, see Parker Tax ¶71,905.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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