By Jane Meacham

The IRS on June 15 released guidance on paying employees from a defined benefit (DB) plan once the participant has entered phased retirement and whether the distributions should be taxed.

The agency issued the guidance, in Notice 2016-39, to answer questions posed about whether such distributions are taxable as DB annuity payments under Section 72 of the Internal Revenue Code.

When it’s not an annuity

The notice explained that payments for an employee from a qualified plan during phased retirement are not received as an annuity for purposes of Section 72 if all the following apply:

1. The employee begins to receive a portion of his or her retirement benefits when entering phased retirement and starting part-time employment and will not begin receiving his or her entire plan benefits until he or she ceases employment and commences full retirement at an indeterminate future time (even if a full retirement date is agreed upon at commencement 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 his or her entire retirement benefit, including the portion that started as phased retirement benefits.

The IRS notice defined phased retirement as an arrangement under which a participant in a qualified defined benefit plan starts the distribution of a portion of his or her retirement benefits from the plan while continuing to work on a part-time basis.

Determining basis recovery fraction

The notice also gave guidance on the present-value factors to be used for determining the basis recovery fraction of each payment received during phased retirement and provides guidance regarding the time for determining the basis recovery fraction for these payments. It offers an example of basis recovery calculations for phased and full retirement payments.

It applies to taxable years beginning on or after January 1, 2016 and modifies IRS Notice 87-13. Taxpayers may elect to apply the new notice to taxable years beginning before that date, the IRS said. The notice does not apply to amounts received from nonqualified contracts.