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 10-year period.
Ten-year averaging is 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. But, you should know that if you use 10-year forward averaging you'll have to use the tax rates in effect as of 1986, which were much higher than our current tax rates.
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 10 for 10-year averaging. Tax is then computed on that result. This tax amount then is multiplied by 10 to arrive at the total tax on the distribution.
Because the tax bracket is computed using only 1/10 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 10-year period.
Example: Let's take a look at Charlie (but don't stare... he's kinda shy). He qualified for 10-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:
1/10 of $80,000 = $8,000.
The tax at unmarried taxpayer rates on $8,000 of income in 1986 is $1,111.
Multiply the tax result by 10 (10 x $1,111 = $11,110). And, this amount is your total tax.
If Charlie didn't elect the 10-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...
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 can also elect to waive applying 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.
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