In 2013, this only applies to plan participants over age 77.

10-year averaging is only available on lump-sum distributions from qualified plans that are not rolled over and only if the plan participant were born before 1936. Capital gain rates can be used for any part of a lump-sum distribution that comes from plan participation before 1974. See the 10-year averaging tables and qualifying information below.

A client or beneficiary would use 10-year averaging if they need most of the money now for living expenses, medical or other pressing bills. If they would have withdrawn most or all of the money anyway, it’s best to use 10-year averaging and pay less tax. If the plan balance is large and they do not need most of the money 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. 10-year averaging requires a lump sum distribution of the ENTIRE plan balance which is now all taxable.

The special 10-year 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. A lump-sum distribution that qualifies for 10-year averaging will not trigger the alternative minimum tax as other retirement plan distributions might. If a husband and wife are each receiving lump-sum distributions, 10-year averaging could reduce the marriage penalty because each spouse calculates the 10-year averaging tax separately. This could happen with a family business that may have closed due to the economic situation. If both spouses were participants in the plan, they could each take a lump-sum distribution in the same year.

10-Year Averaging for Beneficiaries
If the deceased plan participant would have qualified for 10-year averaging (by being born
before 1936), then that option is available to the beneficiary regardless of the beneficiary’s age. Capital gain treatment may also be available if the decedent had plan participation before 1974. Since the non-spouse beneficiary has no rollover option and would likely have to withdraw the entire plan balance in one lump-sum anyway, 10-year averaging and capital gain rates can lower the tax. If it increased the tax (for a very large distribution), you wouldn’t use 10-year averaging. You cannot use 10-year averaging for lump-sum distributions from IRAs or Section 403(b) or 457 plans.

To qualify for 10-year averaging, the plan participant must meet the following tests:

  1. The distribution must be from an IRS qualified plan.
  2. The distribution of the ENTIRE plan balance (not including voluntary 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 1936.
    Beneficiaries can elect averaging, but only if the participant was born before 1936.
  4. The plan participant must have been in the plan for at least five years before the distribution.
  5. The plan participant cannot have used averaging for any previous distribution after 1986.

20% Capital Gain Treatment
If the plan participant was born before 1936 and part of their lump-sum distribution is from pre-1974 plan participation, they can elect on Form 4972 to pay a flat 20% capital gains rate on that portion (that rate remains at 20% under the 2003 Tax Act.). They may also choose not to elect capital gain treatment where averaging produces a lower tax.

How to Figure the Tax Under 10-Year Averaging
The tax break with 10-year averaging is that tax is paid on the total lump-sum distribution as if it were received over 10 years as the only income item. This has the benefit of paying tax at the lowest possible bracket. For instance, with 10-year averaging if the distribution is $200,000, tax is calculated as if you only received $20,000 a year for 10 years. You figure the tax on the $20,000 and multiply that by ten. To put it another way, under our tax system a person who has $200,000 of income will pay more tax than 10 people who have $20,000 each in income. It’s the same total income, but the tax on the 10 people will total much less, and that is the tax break received with special 10-year averaging.

The trade-off, of course, is that the tax is paid in one year and the account no longer grows tax deferred. The tax money that could have been kept growing tax deferred in an IRA rollover account is also lost. But if the plan participant needs the money, averaging is a cheap way to buy it back for most.

Disclosure

The information provided is for educational and informational purposes only. This should not be construed as tax or legal advice. Should you require tax or legal advice, please contact a tax or legal professional licensed to offer advice in your area.