Income tax averaging may reduce your income taxes when you retire. It does this by reducing the amount of income tax you pay in any given year when you take a lump sum distribution. If this places you in a lower tax bracket, then you've successfully saved money on your taxes. It's important to understand when this option is available to you.
Income tax averaging spreads out your income tax liability when you take lump sum distributions from certain retirement accounts. The distribution from the account may be averaged over up to 10 years, thus spreading out your tax liability over this period. Averaging is only allowed when taking lump sum distributions.
Some retirement plans allow you to spread out your tax liability over several years. This gives you the option of paying your taxes all at once or over time. Paying over time may reduce your total liability depending on whether or not you are pushed down into a lower tax bracket by averaging. Pension, profit sharing and stock bonus plans are three types of retirement plans for which tax averaging is allowed. The rules for each type of plan are outlined in IRS publication 554 and publication 575, respectively.
You can't use tax averaging for an IRA. Unfortunately, this means all money withdrawn from an IRA is taxed in the year it is received. You may end up paying more tax than you would with plans that allow tax averaging. This may restrict what you can do in retirement since more of your IRA distributions will go to taxes.
The only real way to avoid paying income taxes on IRA withdrawals is to convert the IRA to a Roth IRA. You pay income tax on the amount of money you convert to the Roth. However, this is a one-time tax payment Future withdrawals from your Roth IRA are generally tax-free. You must keep the Roth account open for at least five years and be at least 59 1/2 when making withdrawals to receive income tax-free withdrawals.
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- Fool.com: Lump-Sum Pension Distribution Tax Issues
- IRS.gov: Publication 575
- IRS.gov: Publication 554