Save tax on retirement payouts with 10-year averaging

Back in the ’90s, Congress wiped off the books one of the most hallowed tax breaks when it repealed five-year “income averaging” on retirement plan payouts. That tax break allowed you to calculate the tax on a lump-sum distribution as if the funds were paid out over five years instead of just one.

But an even better tax break—10-year averaging—managed to avoid the ax.

Strategy: Don’t pass up the special election for 10-year averaging. That tax break is generally reserved for older plan participants born before 1936, but it’s also available to their beneficiaries. So, you might benefit from 10-year averaging even if you were born after the plan participant retired!

What’s more, income averaging isn’t the only tax goody you can grab in this deal. Some recipients may also claim a special capital gains tax break for a portion of the payout.

Here’s the whole story: If you receive a lump-sum distribution and elect 10-year averaging, you must still pay the entire federal income tax bill on the distribution in the year in which you received the funds. But the tax is calculated as if you received the distribution in even amounts over a 10- year period, without regard to other taxable income. In other words, more of the distribution is taxed at lower rates.

Note that this calculation uses the federal income tax rates in effect in 1986. Use Form 4972 (Tax on Lump-Sum Distributions) to figure the tax. (Access the form at www.irs.gov/pub/irs-pdf/f4972.pdf.)

To qualify for the 10-year averaging break, plan participants must have been born before Jan. 1, 1936, and must have participated in the plan for at least five years prior to the distribution year. Beneficiaries are also eligible for the favorable tax treatment, so long as the participant meets the age requirement.

If you qualify for 10-year averaging, you can also make a special capital gains election for the part of the distribution attributable to pre-1974 participation in the plan.

In that case, those amounts are taxed at a flat 20 percent rate, regardless of your top tax rate in the year of the distribution. The remaining distribution portion is figured under the regular 10-year averaging provision.

Is all this worth the hassle? You be the judge. Remember: Retirement plan payouts normally accrue on top of your other ordinary income. That means you could pay federal income tax on a lump-sum distribution at rates as high as 35 percent. However, using the chart at right, you’ll see that you usually pay lower tax using the 10-year averaging.

Example: If you’re in the 35 percent tax bracket, you’d pay $105,000 in tax on a $300,000 payout. With 10-year averaging, the tax is only $66,330.

One lump or two? Plan participants can make the election only one time for a lump-sum distribution. But if you qualify, you can elect averaging as a beneficiary of a distribution and as a participant in your own plan.

The positive impact of 10-year averaging