Typically, when a participant receives annuity payments from a defined benefit pension plan where he or she has a basis in the benefit (what Code Section 72 calls an “investment in the contract”), a portion of the payment is treated as a recovery of that basis. Therefore, it is not taxable to the participant. That portion is determined under the rules of Code Section 72. The most common way in which an employee has basis in his or her benefit is by making after-tax contributions. Currently, this is more common in governmental defined benefit plans than other plans.
However, it was not clear how these basis recovery rules worked in the context of phased retirement distributions. The IRS recently issued Notice 2016-39 to address the treatment of payments made by a qualified defined benefit pension plan to an employee during phased retirement. Phased retirement is the period during which an employee begins to take distributions of a portion of his or her retirement benefits from a plan while continuing to work on a part-time basis. During these periods, it may be difficult for the plan to do the typical calculation under Code Section 72. Additionally, the employee may be continuing to accrue additional benefits, which would further complicate the calculation.
The Notice provides that if certain conditions are met, the payments will not be considered amounts received as an annuity for purposes of Code Section. This means that, if the employee made after-tax contributions to the plan or otherwise has a basis in his or her benefit, then a portion of the payment will be treated as basis recovery and will be excluded from income using the calculation rules under Code Section 72(e)(8) described in the Notice.
According to the Notice, any payments received by an employee from an applicable plan will not be treated as received from an annuity if all the following conditions are met:
- 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;
- The employee will not begin receiving his or her full retirement benefits until ceasing employment and commencing full retirement at an indeterminate future date. For this purpose, a date is “indeterminate” as long as it can be changed. Since the employee and employer can always agree to a later date, nearly every date will be indeterminate for this purpose;
- The plan’s obligations to the employee are based in part on the employee’s continued part-time employment, which impacts both the duration of the phased retirement benefits and the amount of additional retirement benefits the employee accrues during the phased retirement period. In other words, the plan only pays phased retirement benefits as long as the employee is part-time and the employee’s part-time status affects the employee’s ability to accrue benefits under the plan (although the Notice does not appear to say how it affects the accrued benefit); and
- Under the terms of the plan, the employee cannot make an election as to the form of the phased retirement benefit to be paid during phased retirement. Instead, the employee must elect a distribution option at full retirement that applies to the employee’s entire retirement benefit, including the portion that commenced as phased retirement benefits. In other words, the employee’s benefit at full retirement must be reduced by the actuarial equivalent of the amount received during phased retirement.
Any amounts that are not received as an annuity will be subject to the special basis recovery rules in the Notice. Specifically, the amount excludible from the employee’s gross income will be a portion of each payment, calculated 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 present value of the employee’s accrued benefit. The Notice provides that the basis recovery fraction may be fixed at the time payments begin under a phased retirement program. This avoids the need to redo the calculation as the employee makes additional contributions to the plan.
The IRS also issued Revenue Procedure 2016-36, which provides that this Notice will not apply to amounts received from a non-qualified contract.