Citigroup Inc., under pressure from the federal government, took a big step toward breaking up the financial supermarket, entering discussions to spin-off its Smith Barney brokerage unit into a joint venture with rival Morgan Stanley, according to people familiar with the talks.

News of the talks, which could result in an agreement as soon as next week, surfaced Friday afternoon as Robert Rubin, a senior counselor and director at Citigroup, announced his retirement from the New York company. The former Treasury secretary brought...