United States

Taxability of phased pension retirement payments

New IRS guidance provides calculation rules


The IRS released Notice 2016-39 providing guidance on the applicability of section 72 to payments received from a defined benefit plan when employees choose phased retirement. A phased retirement program involves a plan provision that permits an employee to commence receiving benefits at the earlier of age 62 or the plan’s normal retirement age but continue working for the employer on a part-time basis. If a plan provides for phased retirement, the employee can begin receiving partial payments based on his or her current accrued pension benefit while the employee works on a part-time basis and then receive full retirement payments in the future when the employee fully retires and begins to recive his or her final retirement benefit (adjusted for his or her continued years of service).

Some traditional defined benefit plans require employees to make mandatory after-tax contributions in order to participate. In such plans, when an employee retires, a portion of each payment represents a return of the employee’s already taxed money and that portion is accordingly not taxed again. For such plans, phased retirement presents an issue as to how to calculate an emplyee’s return of basis. Section 72 provides rules that apply to determine the taxable portion of payments received from  a qualified retirement plan, as well as certain other contracts. The rules apply differently to amounts received from annuities and to those not received from annuities.

In the notice, the IRS provided three requirements that, if met, allow pension payments received during phased retirement to be treated as payments not received under an annuity. This means generally that a fraction will be calculated to determine the portion of the employee’s basis in the contract as compared to the total expected benefits to be received from the pension plan. That fraction will then determine the portion of each payment received during phased retirement which will be includible in the employee’s income. Of further importance in the notice, the IRS provides that this fraction can be fixed at the time the phased retirement payments commence and does not need to be recalculated periodically.

In the future when the employee fully retires, the payments to be received will be calculated based upon the plan’s terms for taking into account the phased retirement payments already received. The amount of the pension payments to be received in full retirement that will be includible in gross income are amounts received as an annuity and will follow the applicable rules for the recovery of basis of annuity payments.

At the same time as the notice, the IRS released Revenue Procedure 2016-36 to clarify that the notice only applies to payments under an employer’s qualified defined benefit plan and not to payments under nonqualified plans. If phased retirement payments are applicable under a  nonqualified plan, they will be treated as payments received as an annuity and must follow the rules applicable to annuity payments rather than the rules provided in the notice.

The notice is effective for taxable years beginning on or after January 1, 2016, but taxpayers may elect to apply it to earlier taxable years. Employers with pension plans that allow for phased retirement should carefully review the requirements provided in the notice to determine whether their phased retirement program can follow the new rules.


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