Typically, you will be expected to pay taxes on lump-sum IRA distributions in the year you receive them. And the taxes can be pretty huge. Usually, the IRS will impose a mandatory income tax withholding of 20 percent. Your plan administrator will then pay the taxes on your behalf. And that applies even if you roll over the taxable income into a new retirement account within the acceptable 60-day window. And that is where income averaging for retirees was helpful.
What Is Income Averaging?
By employing income averaging, one can factor in the significant variations of the taxable income over a specified period and average them. The strategy is quite helpful in spreading out your tax liability.
Typically, a lump-sum distribution can push you into the high end of the taxable income bracket. However, that lump-sum is likely to come once in many years and is not a true reflection of what you will be making in retirement.
But the lump-sum distribution will be spread out over several years when someone employs income tax averaging. That helps in significantly lowering the taxable IRA distributions. In the end, one is likely to pay a much lower amount than they would if they had not opted for income averaging.
Is Income Averaging Still Allowed by The IRS?
For the general public, income averaging ended in 1986. However, the IRS still allows farmers, fishermen and eligible retirees to employ the strategy to reduce their tax liabilities.
How Income Averaging for Retirees Works
If you are an eligible retiree, you can still perform income tax averaging for lump-sum distributions. The strategy is known as the 10-year forward averaging, forward averaging or 10-year income averaging strategy.
To be eligible:
- You must have been born before January 2, 1936.
- You must be considering taking your retirement funds as a lump sum. That means you must receive the entire distribution in one year without any rollovers.
- The distribution must be from a qualified retirement plan or annuity. Unfortunately, IRA withdrawals don’t qualify.
- You must have been a participant in the retirement plan for five years or more. And if you are a beneficiary of a qualifying plan, you can employ the income averaging strategy provided other factors are constant.
- You cannot have performed income averaging for any distributions you took after 1986.
How the Forward Averaging Strategy Works
When you take your lump-sum distribution, you will divide the amount by 10. You will then apply the 1986 tax rates to the tenth of your distribution. After that, you will multiply that tax amount by 10 to get what you owe in taxes for 10 years. The IRS requires you to pay that tax in the year you receive the entire distribution.
Pros and Cons of Income Averaging
One of the significant benefits of income averaging for retirees is that it treats the distributions as a separate tax calculation from the rest. Also, performing the strategy may enable you to reduce your tax liabilities.
However, based on the 1986 tax rates, 50 percent was what the highest earners paid. Therefore, if your lump sum is significant, you will not benefit much from income averaging. Also, once you take advantage of the process, you cannot defer taxes on those funds.
Income averaging for retirees is not always advisable. It works well if you need a lot of money now for your needs. However, it has strict eligibility criteria and is something you can only use once. Therefore, it may be better to roll over your funds into a different tax-deferred account. Since you have one shot at income tax averaging, you had better make it count. So, before you perform the process, consult a tax advisor.
- IRS: Topic No. 412 Lump-Sum Distributions
- Intuit Turbotax: What is Form 4972: Tax on Lump-Sum Distributions
- The Free Dictionary: Income Averaging
- RBCWM: Ten-year forward averaging
- IRA Help: What You Need to Know About Special 10 Year Income Averaging
- IRS: About Schedule J (Form 1040), Income Averaging for Farmers and Fishermen
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