A provision in the tax code allows use of a special formula called “ten year income averaging” by qualifying individuals or their beneficiaries to determine the tax liability with respect to a lump sum distribution they may receive from an employer-sponsored qualified plan or annuity. This provision is available only if the plan participant was born before January 2, 1936.
The tax under the 10-year averaging option is determined using tax rates that were in effect for single taxpayers in 1986, and is applied to the ordinary income part of the distribution. A flat 20% capital gain rate is also available for the taxable part of a lump-sum distribution that is attributable to plan participation before 1974.
The 10-year income averaging tax is figured separately from regular tax and the income is not added to adjusted gross income. The distribution will not cause a loss of tax deductions, credits or other benefits that are keyed to AGI (adjusted gross income). A lump-sum distribution that qualifies for 10 year income averaging will not trigger the alternative minimum tax as other retirement plan distributions might. And contrary to the provision’s description, the tax is calculated and paid only once, for the year in which the lump sum distribution is received.
To qualify for 10 year income averaging, the following tests must be met:
1. The distribution must be from a tax-qualified retirement plan or annuity; distributions from IRAs don’t qualify.
2. The distribution of the entire plan balance (not including employee contributions) must be made in one taxable year, and no part of the distribution can be rolled over.
3. The plan participant must have been born before January 2, 1936. Beneficiaries can elect income averaging, but only if the participant meets this requirement.
4. The participant must have been in the plan for at least five years before the distribution (does not apply if payment is made to beneficiaries).
5. The plan participant cannot have used the income averaging provision for any previous distribution after 1986.
6. The distribution must be payable:
(1) on account of the employee's death;
(2) after the employee reaches age 59 ½;
(3) on account of a common law employee's separation from service; or
(4) after a self-employed individual has become disabled.
A qualifying plan participant (or his or her beneficiary) would use 10 year income averaging if most of the money is needed now for day to day living expenses or to cover medical or other pressing bills. If most or all of the money is going to be withdrawn anyway, it’s best to use 10 year averaging and pay less tax.
Conversely, if the plan balance is large and most of the money is not needed now, then it would better to roll the funds over to an IRA and withdraw only what is needed. This way, they are not forced to pay tax on money that they don’t need right now.
The 10-year income averaging provision, available only to plan participants age 76 or older (or their beneficiaries), is definitely something worth taking a look at in appropriate situations. You should consult with a financial advisor who is well-versed in this special section of the tax code.
By Marvin Rotenberg and Jared Trexler
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