Phased Retirement: How to Run One at a Small Business

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.

This is the employer side of it: how to build the reduced schedule, what actually 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.

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 round. 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.

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.

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. A 401(k) plan may distribute elective deferrals 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 never adopted an in service distribution provision, nothing can be paid until the employee actually separates, and the income bridge that made the reduced schedule affordable does not exist. Ask your provider this before you discuss any schedule with the employee.

The age matters too. 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, 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.

Two rows deserve expansion. The allocation conditions 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 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. That sits on top of the ordinary participation rules, which let a plan require no more than one year of service, or two years where benefits vest in full immediately (26 U.S.C. 410). The point 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. The mechanics and the credits are covered in the guide to starting a 401(k), and the rule changes affecting eligibility sit in the SECURE 2.0 summary.

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 qualifying event at employers subject to federal COBRA, which reaches private plans where the employer had at least 20 employees, and most states run their own continuation rules below that size.

This 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 practical effect surprises people in both directions. An employee measured as full time 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.

Two related points. Medicare Secondary Payer rules make the group health plan the primary payer 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. Either way, 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.

For salaried exempt employees there is a threshold to watch. The federal salary level for the executive, administrative and professional exemptions is 684 dollars per week, restored by a Department of Labor technical amendment in May 2026 after the 2024 increase was vacated in court. A prorated salary below that level means the exemption no longer applies.

That 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. Front loaded allowances do not fall unless you prorate them deliberately, and it is worth reviewing how the reduced schedule interacts with the leave types you offer before the first reduced paycheck.

One more item people forget: where FMLA reaches your business, an employee needs 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.

Keeping 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 (EEOC).

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 right hand column 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. 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. And if you are asking for a release of claims in exchange for anything, the waiver rules under the Older Workers Benefit Protection Act attach, including minimum consideration periods and a seven day revocation window. The ADEA guide covers those requirements in detail.

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

This 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.

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. The same discipline that makes an offboarding checklist useful applies here, only earlier.

Where This Goes Wrong

Five failures account for most of it, and the first is the expensive one.

Agreeing the schedule before checking the benefits thresholds is first. Two days a week sounds reasonable in a conversation and can put the employee outside the health plan, which turns a friendly arrangement into a coverage loss nobody intended.

Assuming the retirement plan permits in service distributions is second. 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.

Leaving the end date open is third. 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.

Treating the reduced schedule as availability is fourth. 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.

And skipping the successor is last. 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.

One last framing point. Employees watch 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.

Frequently Asked Questions