June 30, 2016

Taxation of Phased Retirement Distributions from Qualified Governmental Defined Benefit Plans

In Notice 2016-39, the Internal Revenue Service (IRS) addresses how to determine the taxable portion of a distribution received by an employee during phased retirement from a qualified governmental defined benefit plan. The IRS concludes that such amounts are taxed as “amounts not received as an annuity” under §72(e) of the Internal Revenue Code (Code), which provides for a pro-rata determination of the nontaxable and taxable portions of the distribution. The Notice allows the taxpayer to determine the pro-rata portion in the first year of distributions due to the phased retirement program and apply that ratio to all distributions during the phased retirement period.

The Notice applies only to distributions from qualified governmental defined benefit plans that receive after-tax contributions (not pre-tax contributions) and provide phased retirement arrangements. The Notice defines a “phased retirement arrangement” as an arrangement under which a participant in a qualified defined benefit plan commences the distribution of a portion of his or her retirement benefits from the plan while continuing to work on a part-time basis. The Notice requires, among other things, that the employee not have an election as to the form of the benefit paid during phased retirement; rather, the employee’s election of a distribution option is made at full retirement and applies to the entire benefit. 

The IRS concurrently released Rev. Proc. 2016-36, which makes clear that the above rule only applies to distributions from qualified defined benefit plans, and not to amounts received from non-qualified plans.

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Serena Simons

Serena Simons

SVP, National Retirement Compliance Practice Leader