10 year averaging is only available to individuals born before 1936.
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.
