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IRS clarifies treatment of payments from qualified plan during phased retirement

Notice 2016-39, 2016-26 IRB ; Rev Proc 2016-36, 2016-26 IRB

In a Notice, IRS has provided guidance as to when payments received by an employee from a qualified retirement plan during phased retirement (i.e., where a qualified defined benefit plan participant commences the distribution of a portion of his retirement benefits while continuing to work on a part-time basis) are amounts received not as an annuity under Code Sec. 72. IRS also contemporaneously issued a Revenue Procedure that excluded from the scope of the Notice amounts received from a non-qualified contract and provided alternative rules on their treatment.

Background. Under Code Sec. 402(a), any amount actually distributed to any distributee by any trust described in Code Sec. 401(a) is taxable to the distributee in the tax year in which distributed under Code Sec. 72.

Code Sec. 72(a) provides that, in general, gross income includes any amount received as an annuity under an annuity, endowment, or life insurance contract, but Code Sec. 72(b)(1) excludes the part of each payment that represents return of investment (e.g., premiums paid) until the entire investment is recovered. The “annuity starting date” is the first day of the first period for which an amount is received as an annuity under the contract. (Code Sec. 72)(c)(4)) Under Code Sec. 72(d), in the case of any amount received as an annuity under a qualified employer retirement plan, including a plan described in Code Sec. 401(a), the nontaxable portion is computed under a simplified method by dividing the investment in the contract by a designated number of monthly payments.

Code Sec. 72(e) provides rules that apply to any amount which is received under an annuity, endowment, or life insurance contract and is not received as an annuity (e.g., cash withdrawals, loans, etc.). Under Code Sec. 72(e)(2)(B), if an amount to which Code Sec. 72(e) applies is received before the annuity starting date, then it is included in gross income to the extent allocable to income on the contract and is excluded from gross income to the extent allocable to the investment in the contract. Code Sec. 72(e)(8) provides special rules for amounts not received as an annuity from a trust or contract described in Code Sec. 72(e)(5)(D) (which includes a qualified retirement plan described in Code Sec. 401(a)). Under those rules, the amount allocated to the investment in the contract is the portion of the distribution which bears the same ratio to the amount of the distribution as the investment in the contract bears to the vested account balance, determined at the time of the distribution or at a time prescribed by IRS.

Amounts subject to Code Sec. 72 are generally considered “amounts received as an annuity” only if (i) the amounts are received on or after the annuity starting date, (ii) the amounts are payable in periodic installments at regular intervals over a period of more than one full year from the annuity starting date, and (iii) subject to certain exceptions, the total of the amounts payable are determinable at the annuity starting date either directly from the terms of the contract or 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. (Reg. § 1.72-2(b)(2))

New guidance. Notice 2016-39 explains how phased retirement payments are treated under Code Sec. 72, as follows.

When payments received by phased retiree during phased retirement are treated as amounts not received as an annuity. A plan’s obligations to an employee receiving phased retirement payments might not be “fixed” within the meaning of Reg. § 1.72-4(b)(1) if, for instance, the employee’s date of full retirement isn’t fixed.

Accordingly, IRS provided that payments received by an employee from a qualified retirement plan during phased retirement are not received as an annuity for Code Sec. 72 if:

i. 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 or her entire plan benefits until he ceases employment and commences full retirement at an indeterminate future time (“indeterminate” meaning that, regardless of whether a date is agreed to, it’s possible that the date could change);
ii. the plan’s obligations to the employee are based in part on the employee’s continued part-time employment); and
iii. 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 the employee’s entire retirement benefit, including the portion that commenced as phased retirement benefits. (Notice 2016-39, Sec. III.A)

Present value factors for purposes of calculating phased retiree’s accrued benefit under Code Sec. 72(e)(8). To the extent the phased retirement payments received from a qualified defined benefit plan during the period of part-time employment are amounts not received as an annuity, the rules of Code Sec. 72(e)(8) (above) apply. If a plan has present value factors that are used for purposes of calculating lump sum distributions (including partial lump sum distributions), those factors (rather than the factors specified in Reg. § 20.2031-7) are to be used in calculating the value of the accrued benefit for purposes of determining the excludible portion of a payment. (Notice 2016-39, Sec. III.B)

Time for determining basis recovery fraction under Code Sec. 72(e)(8). In order to determine the amount allocated to basis under Code Sec. 72(e)(8) and excludible from each phased retirement benefit payment, the basis recovery fraction must be applied to each payment. Generally, the basis recovery fraction is determined as of the date of the payment to which it is applied, but the incremental changes to the basis recovery fraction resulting from any after-tax contributions made during the period of continued part-time employment and changes in the present value of accrued benefits during this period typically would have no more than a minimal effect on the amount excludible from the employee’s phased retirement payments, so IRS has determined that repeated calculation would be unjustifiably burdensome.

Pursuant to the authority provided by Code Sec. 72(e)(8)(B), the basis recovery fraction with respect to a phased retirement payment need not be redetermined as the employee makes additional after-tax contributions and the present value of the accrued benefit changes during the period of part-time employment. Instead, the basis recovery fraction applicable to a series of phased retirement payments is permitted to be fixed at the time those payments commence. When an employee commences full retirement, the employee’s investment in the contract as of the annuity starting date will take into account the investment in the contract recovered during the period of part-time employment and any additional employee contributions made during that period. (Notice 2016-39, Sec. III.C)

Guidance doesn’t apply to amounts received from non-qualified contracts. Noting that Code Sec. 72 differentiates between amounts received from qualified plans and amounts received from non-qualified contracts, particularly in regard to the treatment of amounts that are not received as an annuity, IRS provided that it will not apply Notice 2016-39 to amounts that are received from a non-qualified contract.Rev Proc 2016-36 provides that, in applying the Code Sec. 72 regs cited in Notice 2016-39 to a non-qualified contract, the possibility of further contributions to the contract, or a subsequent election under the contract to receive the benefit payable under the contract in a different manner, generally will not affect the determination of whether distributions are amounts received as an annuity. (Rev Proc 2016-36, Sec. 3.06)

Effective date. Notice 2016-39 and Rev Proc 2016-36 apply to tax years beginning on or after Jan. 1, 2016. Taxpayers may, however, elect to apply them to tax years beginning before that date. (Notice 2016-39, Sec. VI; Rev Proc 2016-36, Sec. 4)

References: For amounts not received as an annuity, see FTC 2d/FIN ¶  J-5053; United States Tax Reporter ¶  724.17; TaxDesk ¶  146,523; TG ¶  12650.