If you do need to take your funds for use, you may qualify for a tax break that the tax law provides to some taxpayers. Taxpayers who were born on or before January 1, 1936 may be eligible for a little known tax break when receiving a lump sum distribution from an employer pension or profit sharing plan. Ten year averaging allows up to 50% of the total distribution to be tax free and the balance will be subject to very low tax rates as described below.

  • Qualifications for the ten year averaging tax:
  • You were born on or before January 1, 1936.
  • You have not made a rollover to an IRA of any part of the plan distribution from the same employer.
  • You have been a participant in the plan for at least five years.
  • You received the distribution in one tax year.

For many taxpayers, the best choice is to elect the ten-year averaging tax using IRS Form 4972 (you can download a copy from www.irs.gov). Here is how the reduced tax is calculated, although it may be best to have a tax professional work out the numbers using a professional quality tax preparation program.

  • Fifty percent of distributions under $20,000 may be exempt from tax.
  • The exempt portion is phased out on distributions from $20,000 to $70,000.
  • Compute tax on 1/10th of taxable pension distribution at 1986 single taxpayer rates (See Form 4972, Page 4).
  • Only the cost (not the value) of employer securities is part of the lump sum amount.
  • Unrealized gain on employer securities is deferred until the securities are sold.

For lump sum distributions of less than $70,000, this election may result in substantial tax savings. However, this is only a very brief and non-technical description of this election, and a careful study of the instructions to Form 4972 is required to determine whether a specific taxpayer is eligible to use this election.

Note: A beneficiary of a taxpayer who is eligible for this election is also eligible to use the election. For example, if the money is in the company plan and the retiree dies, the beneficiary retains this option to withdraw the funds in one tax year and use ten-year forward averaging.

Let’s take a look at the savings in a case where this applies: (1)

Robert C. Smith, who was born in 1935, retired from Crabtree Corporation in 2004. He withdrew the entire amount to his credit from the company’s qualified pension plan. In December 2004, he received a total distribution of $175,000 ($25,000 of employee contributions plus $150,000 of employer contributions and earnings on all contributions). 

The payer gave Robert a Form 1099-R, which shows the capital gain part of the distribution (the part attributable to participation before 1974) to be $10,000. Robert elects 20% capital gain treatment for this part (note that even though the capital gains rate may be different now, the capital gains rate of 20% applies when ten-year averaging is used). A filled-in copy of Robert’s Form 1099-R and Form 4972 follow. He enters $10,000 on Form 4972, Part II, line 6, and $2,000 ($10,000 × 20%) on Part II, line 7.

The ordinary income part of the distribution is $140,000 ($150,000 minus $10,000). Robert elects to figure the tax on this part using the ten-year tax option. He enters $140,000 on Form 4972, Part III, line 8. Then he completes the rest of Form 4972 and includes the tax of $24,270 in the total on line 43 of his Form 1040.

So in Robert’s case, he pays $24,270, or 16% in taxes on a $150,000 distribution. Had he rolled over the distribution to IRA, the ultimate federal tax could have been 35%.

This option will not be favorable for all taxpayers and must be calculated against other alternatives to determine which option appears best. Note that if the taxpayer leaves one employer with assets that qualify for ten year averaging, he may keep that option if the assets are tallied into a conduit IRA, kept separate from other retirement funds, and later rolled into another employer’s qualified plan.

(1) Example from IRS publication 575 2005

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