Question about Form 4972, 10-Year Special Averaging For Lump Sum Distribution

[mlpinvestor]

Hi, all.

I was in Turbotax working on a 1099-R for an inherited 401(k), when it brought up a question about using a "Form 4972 (Tax on Lump-Sum Distributions) for a payment received for this same deceased person."  I had never heard of this, so I searched it out and found this: https://fiscalwisdom.com/what-you-need-to-[product key removed]al-10-year-averaging/.  Apparently, it’s possible to take a total distribution from certain "qualifying" retirement accounts and pay the tax as if it were spread out over ten years in the lowest bracket.

What I can’t find out for sure is whether a 401(k) is a "qualified plan" for purposes of this rule.  This would really work to my advantage if it’s allowed.  Turbotax documentation states that the distribution must be from "a qualified pension, profit-sharing or stock bonus plan, but not from an IRA [or] tax-sheltered annuity (section 403(b) plan)."  However, I don’t know if this is an exhaustive and exclusive list, and it’s not clear why a qualified retirement account like a 401(k) should be treated differently from these other exotic things.  Does the IRS consider a 401(k) an "annuity?"

I do appear to meet the other requirements.  Original participant was born before 1936, no rollovers (just transfer of ownership to beneficiaries), full account value withdrawn, etc.

Thanks for any advice.

[BrittanyS]

A 401k is considered a qualified retirement account.  According to the IRS, a 401K is a "A retirement plan that meets the requirements of Internal Revenue Code Section 401(a) is referred to as a "qualified plan." IRC Section 401(a) sets standards for retirement plans"

If you qualify for form 4972, you will have 5 options to choose from.  See the options below provided by TurboTax:

• partial withdrawal as a capital gain and the remainder as ordinary income
• partial withdrawal as a capital gain.  the remainder use the 10-year tax option
• use the 10-year tax option for the entire withdrawal
• roll over the distribution, and report any withdrawals as ordinary income
• report the entire distribution as ordinary income

• 401k plan qualifications
• What is form 4972?

[mlpinvestor]

Thanks, Brittany.  So it sounds like I should be able to use Form 4972, if you mean to say that 401k plans are eligible for it.  My taxes went way down by doing that.

Curiously, Turbotax didn't actually present me with the capital gain alternatives.  I took the distribution as a single lump sum, so that may be why?  Does it automatically select the option, or combination of options, that will result in the lowest tax when you tell it to use the 10-year method?  By that, I’m referring to the two capital gain alternatives you mentioned, in lieu of or in addition to the 10-year averaging.

Much appreciate the help.

[BrittanyS]

Yes, lump sum payments can cause taxes to go up.  One way to reduce the tax burden is to take smaller distributions instead of one lump sum.  This can help reduce tax bracket jumps that result in higher taxes being paid.  The option would be selected based on the interview questions you answered.  You can view these calculations but viewing the tax return in TurboTax.  To view Online follow these steps:

1. Sign in to TurboTax
2. Select Tax Tools from the left side panel
3. Select Tools
4. Select View Tax Summary
5. Select Preview 1040

To view on the Desktop Version follow these steps

1. Login to TurboTax Desktop
2. Select Forms in the upper right corner
3. Select form 4972

@mlpinvestor 

[Solar Eclipse]

I was looking over this form and had an observation that seemed appropriate as an extension to this discussion...

If I understand the computations correctly, it seems once a lump sum with no capital gains nears $1M the form no longer provides any benefit.  This is not the intended effect from what I understand.  Which leads me to suspect the chart/brackets within the form's instructions have not been (or not adequately been) adjusted for inflation. And probably weren't adjusted for the drop from 40% to 37% top income bracket about 10 years ago.  This is a real shame, especially in light of the harsh 10-year rule now being imposed on non-spouse beneficiaries who are being forced into taking large distributions.  The entire purpose of the 4972 form now seems disjoint from the benefits it was originally designed for.

Any CPA's or other tax experts on the forum have thoughts on this.....am I seeing things correctly?

SE

[dmertz]

The section of the tax code allowing special 10-year averaging refers specifically to the tax-rate schedule in section 1 of the Internal Revenue Code of 1954, so subsequent changes to the tax rate schedule have had no effect on how the tax is calculated with regard to special 10-year averaging.

[Solar Eclipse]

I spent further time researching and experimenting with the 4972 form and wanted to pose some observations (using inherited 401K accounts of a decedent born before 1936 as the baseline example).  Any tax experts please reply if anything I mention below sounds incorrect ...

- Apparently the alternate tax computation which form 4972 offers can be used only ONCE by a beneficiary for a particular decedent.   However, form 4972 can be applied to multiple accounts if they are lump-sum withdrawn in the same year - in which case those amounts would be combined together and treated as one withdrawal for 4972 tax calculation purposes.

- If the total withdrawal amount subject to a form 4972 election approaches, but does not exceed, $850K then the savings can reach approximately $8K.  So there is a substantial benefit to planning accordingly. 

- Tax on lump sum withdrawals do not HAVE to be subjected to form 4972 - it is elective. But ALL accounts that are lump-sum withdrawn in the same year must ALL either take the 4972 election or not.  And there is no restriction on which year following death the lump sum(s) must be withdrawn to be eligible for for 4972. Merely that once a 4972 election is made, it can not be used again in subsequent years for a particular decedent. 

- I believe lump-sum as mentioned above means the 'distribution of the entire balance' as the form language uses - however the way I interpret things is this does NOT mean previous withdrawals make the account ineligible for a 4972 election as would be the case for an NUA.  In other words, regardless of what withdrawals were made previously, it is the year the final lump sum (entire balance) is withdrawn that potentially make the account eligible for a 4972 election.

If my observations above are correct, then it seems wise for beneficiaries try to plan lump-sum withdrawals for a desired year so the total amount approaches, but does not exceed, $850K - and use form 4972 to receive the tax advantage. 

SE

[dmertz]

"the way I interpret things is this does NOT mean previous withdrawals make the account ineligible for a 4972 election as would be the case for an NUA."

As far as I can tell, the same definition for "lump-sum distribution" is used for Form 4972 as is used for NUA, meaning that a distribution after the qualifying event (the death of the participant in this case) but in a year before the year in which Form 4972 is desired to be used would disqualify the use of Form 4972.

Code A (along with the code 4) should be present in box 7 of the Form 1099-R if the distribution is potentially eligible for the special 10-year averaging option.  Code A being absent from box 7 would indicate that the distribution is not eligible for the option.

[Solar Eclipse]

Valid viewpoints, but from researching it seems the lump-sum definition is what helps distinguish a final total distribution from periodic payments (those that are not RMD's or partial withdrawals).  And I've found nothing that links the NUA restrictions to form 4972 in anything I've researched thus far.  The definition of a Qualified Lump-Sum Distribution within the form instructions describe it as follows (shortened):
"The distribution or payment in 1 tax year of a plan participant’s entire balance from all of an employer’s qualified plans of one kind in which the participant had funds. The participant must have been born before January 2, 1936.  If you received a qualified distribution as a beneficiary after the participant’s death, the participant must have been born before January 2, 1936, for you to use this form for that distribution."

I see nothing indicating a lump-sum must be taken in a specific year, nor that any previous partial (non-periodic) distributions, and/or RMD's, disqualifies a complete account distribution taken in a subsequent year from being considered a lump-sum distribution.

If the Total Distribution check-box in box 2b is checked it triggers Turbo Tax to engage the10 year averaging calculations/questions.  So from this it is unclear whether box 7 must contain code A.  Code A states "MAY" qualify for 10 year averaging rule. I'm guessing 401K custodians might elect to put code A in box 7 when there is a total distribution AND the employee/decedent was born before 1936. Turbo Tax appears not to require code A in box 7 and instead asks questions triggered by box 2b.

Let's keep these aspects of the discussion under debate and see if we can determine what the right answers are...

[dmertz]

The only definition that I am aware of for a lump-sum distribution is 26 USC § 402(e)(4)(D).  Various Private Letter Rulings mentioning lump-sum distributions indicate that this definition applies to all of section 402, indicating that it applies equally to both NUA treatment and 10-year averaging.  Also, IRS Notice 87-13 in discussing certain portions of the Tax Reform Act of 1986 indicates that that the same definition of a "lump-sum distribution" applies to both.

What you quoted is the IRS paraphrasing the statute and as a result of paraphrasing appears to omit essential details present in the statute.  The statue defines a lump-sum distribution as the entire balance to the credit of the employee made payable to the recipient due to the qualifying event.  After intervening distributions, the remainder of the balance to the credit would not constitute the entire balance to the credit.

[Solar Eclipse]

Thanks very much for the response and research.  At least one main difference though is it seems that NUA revolves around a qualifying event AND at a time relative to the qualifying event in order to constitute a qualifying NUA distribution.  Whereas there is no such mention with the 10 year average computation, in fact I'm thinking someone could inherit an IRA, do nothing and wait 4 years to take a lump-sum and it would still qualify for 4972 treatment.  The main question I'm stuck on is if there was a prior distribution does that disqualify a later total account distribution from being a qualified lump sum for 4972 purposes.  Further to that, what if in the previous example the beneficiary took only RMD's before the total account distribution, would that disqualify using the 4972 benefits?

BTW, the definition I cited came directly from the instructions on the 4972 form itself. Where it defines qualified lump-sum distribution.

I'm getting the feeling there may be some subtle, key differences when it comes to the definition of a qualifying lump-sum ('total account distribution') for 4972 purposes.  But again, I'm not an expert in this field and value any input from those that work in this realm on a regular basis.

SE

[dmertz]

" it seems that NUA revolves around a qualifying event AND at a time relative to the qualifying event in order to constitute a qualifying NUA distribution."

This derives from the definition of a lump-sum distribution.