Phased Retirement: How to Run One at a Small Business
Phased retirement lets staff cut hours before they leave. What happens to the 401(k) and health plan, how to keep it voluntary, and knowledge transfer.
The best operations person I ever worked with gave four months notice at sixty-three. Four months sounded generous until I sat down and worked out that our vendor renewal dates, our two awkward invoicing exceptions and the reason we did one payroll step manually every quarter existed in exactly one place, which was her head.
What we did about it was not a policy. She moved to three days a week for eight months, kept her health coverage, and spent one of those three days writing things down and sitting with the person taking over. Only later did I find out the arrangement has a name: phased retirement.
This guide is the employer side of it. It covers how to build the reduced schedule, what happens to the retirement plan and the health plan when the hours drop, what keeps the offer voluntary rather than an age discrimination claim in slow motion, and the knowledge transfer mechanics that small employers reliably skip.
I build the people and records tooling for businesses with no HR department at FirstHR. This is general information rather than legal or tax advice.
What Phased Retirement Means
Phased retirement is a defined period during which an employee close to retiring works a reduced schedule instead of leaving on a single date. In the private sector it is a contractual arrangement you design, not a statutory program, which means your plan documents decide most of what is possible.
The federal government runs a formal phased retirement program for its own employees with its own statutory rules. Those rules do not apply to you, and copying the mechanics of a federal program into a private employer handbook is a common way to promise something your plan cannot deliver.
Four numbers shape most of what follows.
Why Small Employers Need It
The case for phased retirement at a small business is not benevolence, it is key person risk. In a company without layers, one person frequently holds a process end to end, and their departure removes both the execution and the reasoning behind it at the same moment.
Large employers absorb this because two other people already do adjacent work. A small team does not have that redundancy. When your longest serving employee leaves, you lose the vendor relationships, the undocumented exceptions and the institutional memory of why a decision was made in the first place.
There is also a recruiting reality. Replacing thirty years of context takes longer than replacing a job description, and the reduced schedule buys you overlap you cannot otherwise get. That overlap is worth more than the salary you save, which is the calculation to run before treating this as a cost.
Designing the Reduced Schedule
Start from the benefits thresholds and work backwards to the schedule, never the other way around. The most common small business mistake is agreeing on two days a week in a friendly conversation and discovering afterwards that two days puts the employee outside the group health plan.
Working backwards means one row per contract, filled in before anybody says a number of days out loud. The lowest surviving threshold on the sheet is the floor your schedule has to clear.
| A | B | C | D | E | F | G | H | I | |
|---|---|---|---|---|---|---|---|---|---|
| 1 | Benefit or plan | Document that governs it | Hours threshold for eligibility | Where the threshold is written | Proposed hours per week | Still eligible | What happens if not | Confirmed with | Date confirmed |
| 2 | Group medical | Plan document and carrier contract | Coverage ends and continuation rules apply | ||||||
| 3 | Dental and vision | Carrier contract | |||||||
| 4 | Basic and voluntary life | Certificate for each product | Carrier definitions are often stricter than the medical plan | ||||||
| 5 | Short term disability | Certificate | |||||||
| 6 | Long term disability | Certificate | |||||||
| 7 | Employer match or profit sharing | Plan document allocation conditions | Hours of service, or employment on the last day of the plan year | The employer money stops while participation continues | |||||
| 8 | In service distributions | Plan document | An age provision rather than an hours threshold | No income bridge, so the whole design changes | |||||
| 9 | Paid time off accrual | Your time off policy | Accrued per hour worked, or front loaded | Front loaded time does not prorate unless you decide it does | |||||
| 10 | Holiday pay | Your time off policy | |||||||
| 11 | FMLA eligibility, where the law reaches you | The statute | 1,250 hours in the 12 months before the leave starts | Job protected leave may not be available when it is needed | |||||
| 12 | Full time status, if you are an applicable large employer | Your measurement method | An average of 30 hours a week or 130 a month | An offer may still be owed through the stability period | |||||
| 13 |
Three schedule shapes cover almost every case. A fixed reduction to three or four days a week is the simplest to administer and the easiest for colleagues to plan around. A tapering schedule steps down over time, which suits a long handover. A seasonal or part year arrangement works where the business has predictable peaks. The table below adds two less common shapes.
| Schedule shape | Best for | The catch |
|---|---|---|
| Fixed three or four days a week | Most roles, and any role others need to schedule around | Pick the days and hold them, or the arrangement erodes into being available all week for less money |
| Tapering reduction over months | Long handovers with a lot to transfer | Each step down can cross a benefits threshold, so check eligibility at every stage rather than once |
| Part year or seasonal | Businesses with predictable peaks | Months with no hours can affect eligibility measurements and accruals in ways monthly schedules do not |
| Same days, shorter days | Roles needing daily presence, such as customer facing work | Rarely delivers real relief to the employee and rarely frees the time for documentation work |
| Project or mentoring only | Senior specialists whose value is judgment rather than throughput | Needs a defined deliverable, or it becomes paid availability with no output |
Whatever shape you pick, write down which specific days. An employee at four days who is asked questions on the fifth is doing a full time job for four days of pay, and that resentment ends good arrangements faster than any benefits problem.
Also decide early whether the reduced role is still the same job. Moving somebody from running a team to documenting processes and mentoring is reasonable if you agree it in advance. Doing it silently, after they accept, looks like the responsibilities were removed because of their age.
The Retirement Plan Question
The question most phased retirement designs turn on is whether the employee can draw retirement money while still working. Payouts to somebody who is still on the payroll are called in service distributions, and whether they exist depends entirely on the plan.
A 401(k) plan may distribute elective deferrals (the money the employee puts in from their paycheck) to a participant who reaches age 59 and a half even if still employed, and a pension plan may permit in service distributions from the same age, but both are optional plan provisions rather than automatic rights (Internal Revenue Service).
That word optional does the work. If your plan document has no in service distribution provision at all, nothing can be paid until the employee actually separates, and the income bridge that made the reduced schedule affordable does not exist. Ask your plan provider before you discuss any schedule with the employee.
Starting age matters too. According to the Internal Revenue Service, distributions taken before 59 and a half generally carry an additional 10 percent early distribution tax unless an exception applies, so a phased retirement starting at 57 is a different financial conversation from one starting at 62.
For defined benefit plans (traditional pensions), the Bipartisan American Miners Act of 2019 lowered the permitted in service distribution age from 62 to 59 and a half, again as an optional amendment (IRS Notice 2020-68).
| Plan feature | What reduced hours do | What to check |
|---|---|---|
| Participation in the plan | Nothing. An existing participant stays a participant | Nothing, but confirm the record is not closed by mistake at the hours change |
| Employee deferrals | Continue from the smaller paycheck at the same percentage | Whether a fixed dollar deferral election now consumes too much of a reduced check |
| Employer match or profit sharing | Can stop entirely if the plan conditions allocations on hours of service or employment on the last day of the plan year | The allocation conditions in the plan document, which most employers have never read |
| Long term part time eligibility | Brings in employees you previously excluded, at 500 hours in two consecutive years | Whether your plan and payroll are tracking hours for this at all |
| In service distributions | Available only if the plan document permits, generally from age 59 and a half | Ask the provider in writing, before promising anything |
| Required minimum distributions | The still working exception can delay them from the current employer plan, where the plan adopted it | Whether the plan document contains the provision, and whether the employee owns more than 5 percent of the business, which removes the exception |
Two rows deserve expansion. The employer match row is where small employers get an unpleasant surprise: an employee who drops to three days may fall short of a service requirement written into the plan (such as a minimum number of hours of service in the year) and receive no match for the year, which nobody notices until the annual statement arrives.
The long term part time row runs the other way. Under the SECURE 2.0 Act, plans must let employees completing at least 500 hours in two consecutive years make elective deferrals for plan years beginning after 2024.
The ordinary participation rules still apply underneath that. They let a plan require no more than one year of service, or two years for employer contributions that vest in full immediately, meaning the employee owns them as soon as they are paid in (26 U.S.C. 410).
The long term part time rule mostly concerns your other part timers, and it is worth confirming whether part time employees are already eligible for your plan.
If you have not set a plan up at all, phased retirement is a poor reason to rush one, but it is a decent reason to look at the numbers.
Health Coverage and Hours
Group health eligibility is set by an hours threshold in your plan document and carrier contract, and falling below it ends coverage. A reduction in hours that causes loss of coverage is itself a COBRA (Consolidated Omnibus Budget Reconciliation Act) qualifying event at employers subject to federal COBRA, which reaches group health plans of employers with 20 or more employees in the prior year (Department of Labor).
COBRA coverage lets the employee stay on the group plan for a time, usually by paying the premium themselves. Many states run their own continuation rules for employers below that 20-employee line (Department of Labor COBRA guide).
The threshold catches employers who assume good intentions are enough. You generally cannot keep somebody on a fully insured group plan when they no longer meet the eligibility definition in the contract, even if you offer to pay the whole premium, because the carrier wrote the definition and the carrier enforces it.
If you are an applicable large employer under the Affordable Care Act, there is a second layer. Full time means an average of at least 30 hours of service per week or 130 hours per month, and employers using the look back measurement method determine status during a stability period from hours worked in an earlier measurement period (Internal Revenue Service).
The timing surprises people twice. Under the Treasury regulations, an employee measured as full time generally keeps that status for the rest of the stability period even after their hours fall, so an offer of coverage may still be required for months after the schedule changes. Then the following measurement period catches up and eligibility ends.
Applicable large employer status is determined on the prior calendar year, so check whether the mandate applies to you before designing around it.
Medicare also decides who pays first once an employee turns 65. Under the Medicare Secondary Payer rules, the group health plan pays first for working employees aged 65 and over where the employer has 20 or more employees, and those employers cannot take Medicare entitlement into account. Below that size, Medicare generally pays first (Medicare.gov).
Whoever pays first, the loss of coverage question is handled through the qualifying event rules rather than by informal arrangement.
Pay, Exempt Status, and Accruals
Prorate the pay to the schedule and keep the rate the same. Cutting the hourly equivalent as well as the hours turns a transition into a demotion, and a demotion attached to somebody nearing retirement is exactly the fact pattern you want to avoid.
Salaried exempt employees, who are not owed overtime, have a salary threshold to watch. Under 29 CFR 541.600, the federal salary level for the executive, administrative and professional exemptions is 684 dollars per week.
A Department of Labor final rule effective May 15, 2026 restored that figure after the 2024 increase was vacated in court. A prorated salary below that level means the exemption no longer applies.
Losing the exemption is not a disaster, but it changes the administration. The employee becomes non exempt, which means tracked hours and overtime at time and a half beyond forty in a week. Several states set higher salary levels than the federal one, so check yours before assuming the federal number governs.
Accruals need a decision rather than a default. Time off that accrues per hour worked falls automatically with the schedule, while front loaded allowances stay put unless you prorate them deliberately. It is worth reviewing how the reduced schedule interacts with the leave types you offer before the schedule changes.
One more item people forget: where FMLA reaches your business, the Department of Labor requires an employee to have 1,250 hours of service in the twelve months before the leave begins, so somebody two years into a reduced schedule may no longer qualify for job protected leave at the moment they most need it. Say that out loud during the conversation rather than letting them discover it.
Dwight SchruteSales3 people
Darryl PhilbinWarehouse1 person
Kelly KapoorCustomer Service1 personKeeping the Offer Voluntary
A phased retirement must be voluntary, and pressing an older worker toward one is age discrimination. The Age Discrimination in Employment Act protects workers aged 40 and over at employers with 20 or more employees and prohibits discrimination in the terms and conditions of employment (Equal Employment Opportunity Commission).
The statute permits genuinely voluntary early retirement incentive arrangements. The exposure is almost never in the arrangement itself. It is in the conversation around it, in who gets approached, and in what happens to the person who says no. The two lists below separate a defensible offer from a pressured one.
The cons list is the whole risk. Each item on its own can be explained. Together they describe an employee who was pushed, and that is what a claim looks like when it is written up eighteen months later by somebody reading back through emails and calendar entries.
Two practical safeguards help. First, never initiate the conversation with a general observation about somebody having been there a long time, because that sentence reappears in every account of the meeting afterwards.
Second, if you are asking for a release of claims (a signed promise by the employee not to sue) in exchange for anything, the waiver rules under the Older Workers Benefit Protection Act apply. The statute requires at least 21 days to consider an individual agreement, or 45 days for a group program, plus a seven day revocation window (29 U.S.C. 626).
Documentation is the cheapest protection available. A short note recording that the employee raised retirement, that the arrangement was offered in response, and that continuing full time remained available, costs five minutes and answers the only question that matters later.
Getting the Knowledge Out
Knowledge transfer is the part small employers get wrong, and it is the part they are actually paying for. A reduced schedule with no transfer obligation attached is a discount on salary in exchange for losing capacity, which is a worse deal than it sounds.
The failure mode is consistent. Everybody agrees knowledge transfer is the point, nobody writes down what specifically must be transferred, and the months pass in ordinary work. In the last two weeks somebody suggests a handover document, and what gets produced is a list of logins.
The inventory step is the one to insist on. Ask the departing employee to list every task only they perform, including the annual ones. Then ask two colleagues what they would come to this person about. The second list always contains items missing from the first, because the most valuable knowledge is the kind its owner has stopped noticing.
Sequencing matters as much as content. Do the annual and quarterly tasks first, because if the arrangement runs eight months and the year end process is documented in month seven, nobody watches it happen live. Anything that only occurs once in a cycle gets scheduled around the cycle rather than around convenience.
Store the output somewhere with a structure. Documents scattered across personal drives and email threads are not transferred knowledge, they are the same problem in a new location. A shared, searchable home with an owner is the minimum, and the principles in knowledge management apply to a two person handover as much as to a large team.
Finally, name the successor early. Documentation written for an unnamed future person is generic and lifeless. Documentation written for Maria, who starts on this next month and does not know the vendor portal, is specific and usable. It also gives the departing employee somebody to correct, which is when the real detail comes out.
Writing It Down
One page is enough, and it beats a formal policy for most small businesses. What you need is a written record of what was agreed, what it changes, and when it ends, signed by both of you. It should cover six points.
Keep the signed agreement with the employee record rather than in a folder somewhere, along with the schedule change and any benefits election that resulted.
Where This Goes Wrong
Five failures account for most of the problems, and the first is the expensive one.
The first failure is agreeing the schedule before checking the benefits thresholds. A schedule that feels reasonable can sit just under the hours line of the health plan, which turns a friendly arrangement into a coverage loss nobody intended.
The second is assuming the retirement plan permits in service distributions. It is an optional provision. Promising an income bridge that the plan document cannot deliver is a conversation you only have to have once to remember.
The third is leaving the end date open. Without one the arrangement drifts, the transfer never finishes, and two years later you have a part time employee, an unwritten process, and no plan for either.
The fourth is treating the reduced schedule as availability. The employee is not at work on their off days. If you call them on those days, either pay for the time or accept that the arrangement will end badly.
The last is skipping the successor. Knowledge transfer without a named recipient produces documents nobody reads, which is the most common way employers spend the money and receive nothing for it. Where the role is genuinely critical, treat it as succession planning rather than as a handover.
Nick Anisimov, FirstHR founderThe rest of the team is watching too. Employees see how the longest serving person is treated on the way out, and they draw conclusions about what happens to them eventually. A phased retirement handled well is visible retention signalling to everybody still on the payroll, which is a return you never see on the invoice.
To start, ask your plan provider and your health carrier to put the in service distribution rule and the hours threshold in writing. Those two answers set how much schedule you can offer, and everything else in the agreement follows from them.
Frequently Asked Questions
What is phased retirement?
Phased retirement means an employee near the end of their career moves to a reduced schedule for a set period instead of leaving on one day. The usual pattern is three days a week, or a part year schedule, for a fixed number of months, often alongside a mentoring or documentation assignment. The employer gets continuity and time to pass on knowledge, and the employee gets a softer landing for both income and identity. In the private sector there is no statutory program behind it, so you build the arrangement yourself, and nearly everything turns on the plan documents that already apply and on what you put in writing.
Can an employee draw from a 401(k) while still working reduced hours?
Only if the plan document permits it. Taking money out while still employed is an optional feature that a plan has to adopt, not something every participant is entitled to. The Internal Revenue Service lets a 401(k) plan pay out elective deferrals to a participant from age 59 and a half whether or not they have left the job, and the Bipartisan American Miners Act of 2019 lets a pension plan make in service distributions from that age if it chooses to. A plan with no in service distribution provision at all cannot pay anything until the employee separates. Check this first, before you promise anybody a phased retirement, because the whole income bridge frequently hinges on it.
Does dropping to part time hours end 401(k) participation?
No. Somebody who already takes part in the plan stays a participant when their hours fall. What can disappear is the employer money. Plenty of plan documents make a match or a profit sharing allocation depend on a minimum number of hours of service during the year, or on whether the person is still on the payroll when the plan year ends, so a cut in hours can quietly end it. A separate rule runs the other direction: the SECURE 2.0 Act requires plans to let employees who put in 500 or more hours in two consecutive years make elective deferrals for plan years starting after 2024, although employer contributions for those employees stay optional.
What happens to health insurance in a phased retirement?
It comes down to the hours threshold written into your plan document and carrier contract. Once the reduced schedule drops below that line, the employee stops being eligible, and where federal COBRA applies, a cut in hours that costs someone their coverage counts as a qualifying event. Applicable large employers, as the Affordable Care Act defines them, face a second test. Full time there means averaging at least 30 hours of service a week, or 130 a month, and an employer that uses the look back measurement method generally has to keep treating the person as full time through the rest of the stability period, even after their hours have dropped. Confirm both before you agree a schedule.
Is phased retirement age discrimination?
Offering it is not. Pressuring somebody into it is. The Age Discrimination in Employment Act covers workers aged 40 and over and applies to employers with 20 or more employees, and it does allow early retirement incentives that are truly voluntary. The risk sits in how the offer is handled: approaching only older workers, asking again after a no, hinting that a layoff follows a refusal, or taking responsibilities away from someone who declines. Protect yourself by offering the arrangement on stated criteria, letting people decline without consequence, giving them time to think it over, and recording that the request came from the employee whenever it did.
How long should a phased retirement last?
Most work well between six and eighteen months, with a written end date from the start. Shorter than about six months and the knowledge transfer becomes a rushed handover with the schedule reduction attached for no real benefit. Longer than about eighteen months and it stops being a transition and becomes a permanent part time role, which is a legitimate arrangement but a different one that deserves its own job description and its own benefits analysis. Set the end date at the outset and extend deliberately if you need to, rather than leaving it open and discovering two years later that nobody ever agreed when it finished.
Should a phased retiree keep the same title and pay rate?
Usually the same title and the same hourly equivalent, with pay prorated to the reduced schedule. Lowering the rate along with the hours looks like a demotion and weakens the voluntariness that makes the arrangement defensible. If the job really does change, say a team manager who becomes the person writing procedures and coaching a successor, a new title is reasonable provided the employee agrees to it beforehand. Watch salaried exempt staff in particular: when a prorated salary lands under the federal level of 684 dollars per week, the exemption stops applying and overtime rules cover the reduced schedule. A number of states set a higher salary level than the federal one, so look up yours before relying on the federal figure.
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