IRS Issues Guidance on the Treatment of Phased Retirement Payments Under Code Section 72 | Practical Law

IRS Issues Guidance on the Treatment of Phased Retirement Payments Under Code Section 72 | Practical Law

The Internal Revenue Service (IRS) issued Notice 2016-39, which provides guidance on whether qualified defined benefit plan payments to an employee during a phased retirement are received as an annuity under Section 72 of the Internal Revenue Code. The IRS also issued Revenue Procedure 2016-36, which excludes amounts received from a non-qualified contract from the requirements of Notice 2016-39.

IRS Issues Guidance on the Treatment of Phased Retirement Payments Under Code Section 72

by Practical Law Employee Benefits & Executive Compensation
Published on 14 Jun 2016 • USA (National/Federal)
The Internal Revenue Service (IRS) issued Notice 2016-39, which provides guidance on whether qualified defined benefit plan payments to an employee during a phased retirement are received as an annuity under Section 72 of the Internal Revenue Code. The IRS also issued Revenue Procedure 2016-36, which excludes amounts received from a non-qualified contract from the requirements of Notice 2016-39.
On June 10, 2016, the IRS issued Notice 2016-39 () and Revenue Procedure 2016-36 (). Notice 2016-39 provides guidance as to whether payments received by an employee from a defined benefit plan during a phased retirement are amounts received as an annuity under Section 72 of the Internal Revenue Code (Code). Revenue Procedure 2016-36 provides that the requirements of Notice 2016-39 do not apply to amounts received from a non-qualified contract.

Background

Amounts received as an annuity are taxable to the distributee under Code Section 72 in the tax year in which they are distributed (26 U.S.C. § 402(a)). Treasury Regulation Section 1.72-2(b)(2) provides when amounts taxable under Code Section 72 are considered "amounts received as an annuity." Amounts subject to Code Section 72 are generally considered "amounts received as an annuity" only if:
  • The amounts are received on or after the annuity starting date.
  • The amounts are payable in periodic installments at regular intervals over a period of more than one full year from the annuity starting date.
  • The total of the amounts payable are determinable at the annuity starting date either:
    • directly from the terms of the contract;
    • indirectly by the use of either mortality tables or compound interest computations; or
    • both, in conjunction with the terms of the contract and in accordance with sound actuarial theory.
The IRS issued this guidance on how Code Section 72 applies to phased retirement benefits because an employee's phased retirement payments may not clearly satisfy these conditions. For example, his date of retirement is not necessarily fixed such as in the case if an employee continues to work part time for the employer after retirement.

Notice 2016-39

For purposes of Notice 2016-39, a phased retirement is an arrangement under which a participant in a qualified defined benefit plan commences the distribution of a portion of his retirement benefits from the plan while he continues to work on a part-time basis.
The annuity rules under Code Section 72 (26 U.S.C. § 72) provide that distributions received as an annuity are includible in gross income except to the extent the distribution is a non-taxable return of investment. If payments are received as an annuity for purposes of Code Section 72, they are taxable to the distributee in the tax year in which they are distributed (26 U.S.C. § 402(a)).
Under Notice 2016-39, payments received by an employee from a qualified retirement plan during phased retirement are not considered "received as an annuity" under Code Section 72 if:
  • The employee begins to receive a portion of his retirement benefits when he enters phased retirement and begins part-time employment, and will not begin receiving his entire plan benefits until he ceases employment and commences full retirement at an indeterminate future time. Even if a full retirement date is agreed upon when the phased retirement begins, the date of full retirement is considered indeterminate if it is possible that date could change.
  • 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 phased retirement benefits and the amount of additional retirement benefits the employee accrues during the period of part-time employment).
  • Under the plan, the employee does not have an election as to the form of the phased retirement benefit to be paid during phased retirement. Rather, the employee 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 satisfied in a phased retirement, the employee recovers investment in the contract under the rules in Code Section 72(e)(8).
Notice 2016-39 also provides guidance on:
  • The appropriate present value factors to be used for purposes of determining the basis recovery fraction of each payment received during phased retirement. If a plan has present value factors that are used to calculate lump sum distributions (including partial lump sum distributions), those factors (rather than the factors specified in Treasury Regulation Section 20.2031-7) must be used to calculate the value of the accrued benefit to determine the excludible portion of a payment.
  • The time for determining the basis recovery fraction for these phased retirement payments.
The Notice includes examples of basis recovery calculations for phased retirement and full retirement payments.

Revenue Procedure 2016-36

Revenue Procedure 2016-36 provides that the IRS will not apply Notice 2016-39 to amounts received from a non-qualified contract. In applying Treasury Regulation Sections 1.72-2(b)(2) and 1.72-4(b)(1) to a non-qualified contract, the possibility of further contributions to the contract or a subsequent election under the contract to receive the benefit in a different manner generally will not affect whether the payments are amounts received as an annuity.
The Revenue Procedure does not apply to amounts to which Code Section 72 applies that are received under a qualified defined benefit plan under Code Section 72(e)(5)(D) (26 U.S.C. § 72(e)(5)(D)).

Effective Date

Notice 2016-39 and Revenue Procedure 2016-36 apply to taxable years beginning on or after January 1, 2016. Taxpayers, however, may apply the guidance to taxable years beginning before that date.

Practical Implications

The latest IRS guidance responds to questions regarding the taxation of payments from a qualified defined benefit plan during phased retirement. Defined benefit plan sponsors, especially those that permit phased retirement, should familiarize themselves with this guidance, particularly the requirements for allowing employees receiving payments in phased retirement to avoid taxation under Code Section 72 and to ensure that this guidance is followed.