If you receive a "lump-sum" distribution from
certain qualified pension and profit-sharing plans,
you have the ability to elect a special tax treatment
called "forward averaging." This averaging is
completely different from the old "income
averaging" that many of you may still remember (at
least those of us with a few tax years under our
belts).
But these "lump-sum" distributions are special. Not
just any distribution qualifies as a "lump sum." The
rules can get pretty complex... but, generally, a
lump-sum distribution is one in which the entire
balance of your retirement account is distributed to
you (or your beneficiaries). This distribution must
be given to you in a single taxable year, and is paid
to you (or your beneficiaries) for any of the
following reasons:
- Because of your death;
- At any time after you've attained age 59 1/2;
- Because you become disabled (but this category applies ONLY to self-employed individuals); or
- Because of your separation from service of your employer (but this category does NOT apply to self-employed individuals).
Additionally, for a distribution to be considered a
lump-sum distribution, you must have been a
participant in the plan for five or more (not
necessarily consecutive) years preceding the year
of the distribution.
OK... so what does this all mean?
At this point, you may be asking, "So what?" Well... here's what. If your
distribution qualifies as a lump-sum distribution, you have special tax rates
available to you that could save you considerable tax dollars on your
pension distribution.
The principal advantage to lump-sum tax treatment is the ability to use
"forward averaging." Under certain rules, part of the distribution also may
qualify for capital gains treatment. In effect, you can "average" the tax bite
on your qualified distribution over a 5- or 10-year period.
But, there is some bad news that you should be aware of. The 5-year
forward-averaging rules were repealed by the Small Business Job
Protection Act, effective for tax year 2000 (that is…1999 was potentially
your last bite at the apple). However, all isn't lost yet... there are certain
transitional rules that may still help you save some tax dollars.
Ten-year averaging is still available for any of you who attained age 50
prior to January 1, 1986. Simply put, the 10-year averaging rules are
available to you if you were born before 1936. Additionally, if you were
born before 1936, you have the option of using either 10-year averaging
at 1986 tax rates or 5-year averaging using the current year tax rates (that
is... the year in which you file your taxes using the 5-year averaging
method). This is the transitional rule that may allow you to use 5-year
averaging... even after 1999.
Once lump-sum treatment is elected, all distributions from qualified plans
to the recipient for that taxable year must use lump-sum treatment. Failure
to include all lump-sum distributions in the election will invalidate the
election for any distributions that were included. Finally, know that you
can only make one forward-averaging election during your lifetime.
The amount of a distribution subject to forward averaging is taxed
separately from any other income that you might have. This allows you to
take advantage of the lowest tax brackets a second time, instead of having
the entire distribution taxed at your highest marginal tax rate for the year of
the distribution.
How far forward?
The term "forward averaging" applied to this method of taxation is derived
from the fact that the tax on the distribution is computed first by dividing
the taxable portion of the distribution by 5 for 5-year averaging (or 10 in
the case of 10-year averaging). Tax is then computed on that result. This
tax amount then is multiplied by 5 (or 10) to arrive at the total tax on the
distribution.
Because the tax bracket is computed using only one-fifth or one-tenth of
the total distribution, this can produce a lower overall tax on the
distribution than would have been paid if the distribution had been treated
as a lump sum entirely subject to tax in a single year. Sound great? It is.
Only one little problem -- the full forward-averaging tax due must be paid
in the year of the distribution, and not over a 5- or 10-year period.
Example: Let's take a look at Charlie (but don't stare... he's kinda shy).
He qualified for 5-year averaging treatment. His total distribution is
$80,000. The tax on the distribution using five-year forward averaging is
$12,000, computed as follows:
- 1/5 of $80,000 = $16,000. (Divide $80,000 by 5 for 5-year
averaging)
- The tax at unmarried taxpayer rates on $16,000 of income in 1998
is $2,400.
- 5 x $2,400 = $12,000.
If Charlie didn't elect the 5-year averaging method, his tax on this income
would likely be considerably higher, since all of this income would be
taxed at a much higher bracket.
Additional modifications must be made if the taxable portion of the
distribution is less than $70,000. This can make the computations a little
dicier. So, if your taxable distribution is less than $70,000 and qualifies for
lump-sum distribution treatment, make sure that you do some additional
reading on this subject.
And don't forget...
Remember that not all of a lump-sum distribution is subject to forward
averaging. Some of the distribution may be treated as a capital gain under
a transition election afforded by the 1986 Tax Reform Act.
In addition, the portion of a distribution that is your original after-tax
contributions to the plan is not taxable. Period. You receive those funds
back tax-free (seems only right since you didn't receive any tax benefit
when you originally made the after-tax contributions, eh?). And, because
you receive those funds back tax-free, they can't be included in your
forward-averaging computations.
Finally, if employer securities are part of the distribution, any net
unrealized appreciation in their value is subtracted from the total taxable
amount of the distribution before applying forward averaging. But you may
also elect to waive application of the net unrealized appreciation exclusion
and have the value of the securities included in the amount subject to
forward averaging.
Sound confusing? It sure can be, and the rules can be difficult to follow.
So, before you do too much with forward averaging, you'll really want to
read IRS Publication 554 and Publication 575 at the IRS website. And, while you're there, you should also check out IRS Form 4972 and the associated instructions.
- October 1, 1999
