The latest IRS guidance on taxation of participants’ benefits distributed during phased retirement begs the question—whatever happened to phased retirement? It garnered a lot of publicity a few years ago but hasn’t seemed to have caught on.

Background

It became painfully evident to employers over the last decade that, as Baby Boomers approached retirement age and left the workforce, a tremendous amount of institutional knowledge and job experience was walking out the door with them. In many cases, there were either no skilled workers or only a limited pool of skilled workers to take the place of the retiring employees.

As a result, the idea of phased retirement began to surface.

Phased retirement can mean reduced hours; flexible hours or a combination of reduced and flexible hours, rehiring retired employees as independent contractors; or rehiring a former employee after a certain amount of time has passed. The variations are many.

Therefore, a key aspect of phased retirement important for both participants and employer plan sponsors is the possibility for eligible employees to begin receiving benefit payments from their retirement plans while still working.

Roadblocks to implementation

Defined contribution plans have fewer impediments for phased retirement than do defined benefit (DB) pensions due to the availability of withdrawals without penalty for participants starting at age 59½. DB plans generally require a separation from service and satisfaction of age and service criteria contained in the plan document before benefit payments can begin.

In 2004, the IRS issued proposed regulations on phased retirement that could not be relied upon until the regulations were finalized. There has been no further guidance on the 2004 proposed phased retirement regulations.

The proposed regulations’ requirements included:

• A bona fide phased retirement program that was written and voluntary in nature.
• A reduction in work hours for the participant by 20%. Periodic testing would be required to ensure compliance.
• Attainment by the participant of age 59½.
• Nondiscrimination testing.

The Pension Protection Act of 2006 included a provision allowing inservice distributions to plan participants age 62 and over. In 2007, the IRS issued Notice 2007-8 requesting comments on specific questions relating to the amount of the benefit payable at age 62, early-retirement subsidies, and whether final regulations relating to phased retirement plans should be issued. Finally, in 2007, the IRS issued final regulations permitting inservice distributions after age 62, even if a plan established a higher age for normal retirement.

The 2008 ERISA Advisory Council issued a report on phased retirement. The report made the following recommendations:

• The U.S. Department of Labor (DOL) should act as a catalyst to influence the IRS in making changes that would provide flexibility to employers and employees in the phased retirement plan area.
• Any regulatory requirements should not be overly burdensome to employers and should not impose too many new requirements.
• The DOL should create resources and educational material that would help employers and employees understand the implications of phased retirement.

Given the lack of clear guidance on benefits payouts from defined benefit plans for participants who are actively working, it’s easy to see why corporate phased retirement programs haven’t gained much traction.

However, the 2012 ‘‘Moving Ahead for Progress in the 21st Century Act’’ (MAP–21) required the Office of Personnel Management to publish regulations implementing phased retirement for federal workers under the Civil Service Retirement System (CSRS) and the Federal Employees’ Retirement System (FERS). Final regulations for those federal retirement plans were issued in August 2014 and were effective in November of the same year; they may provide some guidelines for corporations.

As outlined on the government’s website participation in the federal phase retirement program is entirely voluntary and requires the mutual consent of both the employee and employing agency.

In order to participate, an individual must have been employed on a full-time basis for the preceding 3 years. Under CSRS, the individual must be eligible for immediate retirement with at least 30 years of service at age 55 or with 20 years of service at age 60. Under the FERS, the individual must be eligible for immediate retirement with at least 30 years of service at MRA (minimum retirement age 55 to 57, depending upon year of birth) or with 20 years of service at age 60.

In addition, continued employment could take some pressure off the embattled U.S. Social Security system and other countries’ similar government retirement subsidies.

Survey says …

In the past few years, surveys concerning phased retirement have begun focusing on phased retirement in the private sector.

Boston College published Phased Retirement: Employee and Employer Perspectives in August 2014. Its findings were:

• Workers viewed retirement as a gradual process. Opportunities for phased retirement were an important aspect of a job. Many workers were already semiretired or retired and working in a different line of work.
• Survey results varied. One survey revealed that half of the organizations offered some kind of phased retirement to some employees while other surveys found that approximately 20% of companies offered phased retirement.
• Legal and regulatory considerations are perceived to be a barrier preventing employers from moving forward with phased retirement.

The Pew Research Center reported that more Americans aged 65 and older are working now than in the past. The Bureau of Labor Statistics indicated that 18.8% of Americans over 65 were working in a May 2016 report, up from 12.8% in 2000. All senior age brackets, 65to 69, 70 to 74, and 75 and older are working at greater rates than in the past.

The National Bureau of Education Research reports that many of the older workers around the world have the capacity to work longer than they currently are.

A turbulent economy, increased longevity, better health, limited employment opportunities for older workers, and insufficient retirement savings all might fuel the trend of people staying in the workforce longer.

Key takeaways

With so much evidence showing that phased retirements are favored by employees, final IRS regulations that determine how to tax benefits distributions during that period are critical.

Clear, simple guidance from the agency—together with increased DOL educational and outreach efforts—could go a long way to enable employees to work longer with their current employers, reducing brain drain and the loss of institutional memory.