IRS offers guidance on taxation of phased retirement payments

Phased retirement has become an increasingly popular trend lately. Along with its increased use, however, a number of questions have arisen. The IRS recently has issued guidance for determining the taxable portion of payments made to an employee during phased retirement. The guidance explains whether the payments are “received as an annuity” under Code Sec. 72 and how to determine the taxable portion of payments that are not received as an annuity.

Phased Retirement

Phased retirement is an arrangement where an employee (the “participant”) in a qualified defined benefit plan elects to keep working on a part-time basis, rather than completely retire and take full benefits. The employer and the employee agree that an employee will work part-time for a specified period. However, the parties may agree at any time to change the period of part-time employment.

During phased retirement, the employer pays the participant a portion of his or her full retirement benefits, in the form of a single life annuity. At the same time, the employee continues to earn additional retirement benefits and to make additional contributions. The guidance provides an example where the employee in phased retirement works 40 percent of his full-time schedule. During part-time employment, the employee receives payments equal to 60 percent of the employee’s benefit at full retirement. Thus, for example, an employee who would be entitled to a single life annuity of $2,000 a month at full retirement would receive $1,200 a month during part-time employment.

When the part-time employee terminates all employment, the employee begins to receive an annuity based on full retirement. The employee’s total retirement benefit equals the monthly benefit paid during phased retirement, increased by a cost-of-living adjustment and an additional amount.

Non-Annuity Payments

Under Code Sec. 72(e), amounts not received as an annuity are excluded from gross income if allocated to investment in the contract. Code Sec. 72(e)(8) provides for the pro rata recovery of the employee’s contributions. The ratio of the investment in the contract to the vested account balance (the “basis recovery fraction”) determines the nontaxable portion of each payment.

A plan’s obligations to the employee at full retirement may not be fixed and determinable for an employee receiving phased retirement payments, if: the plan’s obligations depend on the employee’s continued part-time employment; the employee will not receive full retirement benefits until ceasing employment at an undetermined time; and the employee can elect a distribution option at full retirement. If these conditions apply, the payments made during phased retirement are not received as an annuity. As a result, the taxable and excludible portions of the payments must be determined under Code Sec. 72(e)(8), by applying the basis recovery fraction to each phased retirement payment.

Written by

Steve Moss, CPA is a partner at Holden Moss CPAs and loves helping businesses and their owners grow to be the very best they can be. Our other offices include Raleigh, Oxford and Warrenton.

We are a little different at Holden Moss CPAs. While we still provide traditional tax and accounting services, years ago we realized many clients wanted help in running their businesses and were hungry for ideas, solutions, strategy, and execution. In response, we expanded our skill set and joined Ran One, a global network of business consulting firms. Our membership with Ran One gives us access to proprietary resources and analytical software to help our clients grow, become more profitable and valuable, and have the lifestyle they desire.

Now, blended into the fabric of our normal tax and accounting needs, we are focused on our clients’ businesses in a very different way. While our approach is not right for everyone, for those whom it is, incredible results may be obtained. Whether you have a new, or established, business, or for those in transition of selling or retiring, or for those who simply need to develop an exit strategy or succession plan, our unique approach to client service may be the edge you need.

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