How to Calculate the Investment in the Contract for Phased Retirement Distributions

When an employee continues working part time for his or her employer after retirement and receives a reduced portion of his or her retirement benefits from a defined benefit plan, it has been unclear whether those amounts qualify as amounts received as an annuity under Sec. 72. The IRS has now issued guidance on how to determine the investment in the contract for calculating the tax under Sec. 72 in such cases (called phased retirement) (Notice 2016-39). It also issued guidance on amounts received under a nonqualified contract (Rev. Proc. 2016-36).

Sec. 72 provides that distributions from an annuity, endowment, or life insurance contract are included in gross income except to the extent the distribution is a nontaxable return of investment. To determine that, Sec. 72 distinguishes between “amounts received as an annuity” and “amounts not received as an annuity.”

Periodic phased retirement benefits do not qualify as amounts received as an annuity if all the following conditions apply:

• 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 and will not begin receiving his or her entire plan benefits until he or she begins full retirement at an indeterminate future time (for this purpose, even if the full retirement date is agreed upon from the beginning, the employee’s date of full retirement is indeterminate as long as it could change);
• The plan’s obligations to the employee are based in part on the employee’s continued part-time employment (which affects both the length of the payment of phased retirement benefits and the amount of additional retirement benefits accrued during that period); and
• The plan does not permit the employee to elect 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 began as phased benefits.

Because, under these conditions, the benefits are amounts not received as an annuity that are paid under a qualified defined benefit plan, the employee recovers investment in the contract under the rules in Sec. 72(e)(8), which say that the amount allocated to the investment in the contract is the portion of the distribution that bears the same ratio to the amount of the distribution as the investment in the contract bears to the vested account balance. The notice explains that present value factors apply and provides an example containing calculations for a specific hypothetical employee.

In Rev. Proc. 2016-36, the IRS explains that the rules contained in Notice 2016-39 do not apply to a nonqualified plan, and says that, in applying Regs. Secs. 1.72-2(b)(2) and 1.72-4(b)(1) to amounts to which Sec. 72 applies that are received from a nonqualified contract, the possibility of further contributions to the contract or a subsequent election under the contract to receive the benefit in a different manner generally will not affect the determination of whether payments are amounts received as an annuity.

The notice and revenue procedure are effective for tax years beginning on or after Jan. 1, 2016, but taxpayers may apply them retroactively.

—Sally P. Schreiber (sschreiber@aicpa.org) is a Tax Adviser senior editor.