Lump-Sum Distributions

Distributions from retirement accounts can either be lump sums or periodic payments, depending on the choice of the account owner. However, married taxpayers must obtain the consent of the spouse to elect a lump-sum distribution.

A lump-sum distribution is a distribution of the entire balance of a qualified retirement plan within one tax year. Thus, a series of payments received within one tax year will be considered a lump-sum distribution if the entire balance of a particular type of retirement plan, such as a profit sharing, pension, or stock bonus plan, will be considered a lump-sum distribution. Deductible voluntary contributions made after 1981, but before 1987, cannot be distributed as a lump sum.

Pretax contributions are taxable upon distribution, but any distribution of after-tax contributions plus any net unrealized appreciation in the securities of the employer that are included in the lump sum are tax-free.

A distribution from a pretax retirement account, whether it be a lump sum or periodic payments, will be subject to tax for the year in which the distribution was received. A tax on a lump-sum distribution can be avoided if it is rolled over to another retirement account within 60 days of receiving it. However, the plan administrator is required to withhold 20% of the distribution for the payment of taxes. The 20% withholding can be avoided if the rollover is done as a direct transfer, from trustee to trustee. If the distribution is received, then the taxpayer should add an amount equal to the 20% withheld when rolling over the distribution to another retirement account so that the entire amount of the distribution is rolled over tax-free.

A taxable lump-sum distribution is reported as ordinary pension income on Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., unless the taxpayer was born before January 2, 1936, in which case, a special averaging procedure can be used.

Requirements for 10-Year Averaging and the Capital Gain Election

The 10-year averaging method can only be used once in a lifetime and only by those born before January 2, 1936 or a beneficiary of the eligible taxpayer. If the taxpayer participated in the retirement plan before 1974, then the taxpayer may elect to apply a special 20% capital gain rate to the lump-sum distribution that is attributed to contributions before 1974.

However, averaging and capital gains treatment are not permitted for lump-sum distributions if any of the following apply:

Whether a beneficiary can use averaging depends on the deceased plan participant's age, but the 5-year participation rule does not apply.

If a distribution is received by a spouse or former spouse because of a qualified domestic relations order, then the recipient may choose to rollover the distribution tax-free, or, in certain cases, to use special averaging, if the participant qualified for special averaging.

10-Year Averaging Option For Those Born Before January 2, 1936

If a distribution recipient was born before January 2, 1936, then he can choose to pay tax using the averaging method or rollover the amount tax-free to another retirement account. However, if the taxpayer receives more than 1 lump sum during the tax year, then the same choice must be made for all the distributions. So a taxpayer cannot choose to use the averaging method for 1 distribution and to rollover the amount of another distribution.

If the distribution is paid directly to the taxpayer, then the trustee is required to withhold 20% of the amount for taxes. Therefore, to make the entire rollover tax-free, the taxpayer must pay the additional 20% that was withheld and then claim a paid-tax credit on the tax return. Averaging can only be used 1 time after 1986.

If a taxpayer who is eligible for averaging changes jobs, then any amounts in the retirement plan of the former employer can be rolled over to a retirement account at the new employer. However, if the rollover cannot be directly transferred, the taxpayer can choose to rollover the money into a conduit IRA for the express purpose of holding the amount until it can be rolled over to another qualified retirement plan. To remain eligible for averaging, no other contribution should be made to the conduit IRA; otherwise, the money in the conduit IRA will no longer be eligible for averaging, even if it is rolled over into another retirement plan.

The election to rollover the money to an IRA is an irrevocable decision that cannot be revoked. If it is, then the entire amount will be includible as income and there may be a 10% tax penalty if the taxpayer is younger than 59½.

In community property states, for married couples filing separately, only the spouse who earned the lump sum may use 10-year averaging; the other spouse is not taxed on the distribution. So if a husband receives $20,000 as a lump-sum distribution and chooses not to average, then $10,000 of that distribution must be reported on his return and $10,000 must be reported on his wife's return, if they filed separately. If the husband chooses to average instead, then the husband must claim the entire $20,000 on his own return while his wife would not claim any part of the distribution.

A taxpayer who is prevented from electing averaging for a lump-sum distribution from her own plan can still make the election as a beneficiary of a deceased plan participant who was eligible for averaging.

If a beneficiary receives more than 1 lump-sum distribution from the account of the deceased owner who is eligible for the special averaging, then the beneficiary can elect to use special averaging, but the election must apply to all the lump-sum distributions received from the retirement plan. If the beneficiary dies before receiving the distribution, then the beneficiary of the beneficiary is not entitled to the lump-sum treatment.

If a qualifying lump sum is paid either to a trust or to the estate of the participant, then either the employee, or, if deceased, the personal representative of the estate can choose to use the special averaging method.

If the retirement plan loses its exempt status, then any amounts in the account will no longer be eligible for averaging, even though it is not the taxpayer's fault that the retirement plan of the employer became disqualified.

Use Form 4972 to Average

Averaging is calculated on Form 4972, Tax on Lump-Sum Distributions. The basic procedure is to divide the lump-sum distribution by 10, then calculate the tax using the Tax Rate Schedule in the instructions to Form 4972. The marginal tax rate ranges from 11% to 50%, so the net effect of averaging is that a lower marginal tax rate is applied to the distribution. This annual tax is then multiplied by 10 to arrive at the total tax.

If the taxpayer elects capital gain treatment for pre-1974 participation, then a 20% capital gains rate is applied to that amount, which is subtracted from the lump-sum distribution before calculating the 10-year averaging.

The portion of the distribution that includes capital gain is listed in the capital gain box of Form 1099-R. The 20% capital gains rate is fixed and does not depend on the current capital gain percentage. Only taxpayers who qualify for special averaging can use the special capital gains treatment. The taxpayer may choose to include the capital gain as ordinary income subject to special averaging. However, in no case can the capital gain be reported on Scheduled D, the form in which most capital gains are ordinarily reported.

Example: Using Special Averaging to Calculate Taxable Lump-Sum Distributions
Lump-Sum Distribution $200,000
Capital Gain Portion Attributable to Pre-1974 Participation $30,000
Tax on Capital Gain Portion $6,000 Capital Gain Portion × 20%
Amount Subject to Special Averaging $170,000 = Lump-Sum DistributionCapital Gain Portion
10% of Amount Subject to Special Averaging $17,000
Tax on the Annual Amount $2,917 Determined by the Tax Rate Schedule in the Instructions for Form 4972
Multiply the Annual Tax by 10 $29,170
Tax on the Part of the Lump-Sum Distribution Subject to Averaging + Tax on Capital Gain Portion $35,170