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Progar & Company, P.A.

Certified Public Accounting services for businesses and individuals

Lump-sum distribution-ten year averaging option for older employees (MS Word) 

Lump-sum distribution- ten year averaging option for older employees (.pdf)

 

Lump-sum distribution—ten year averaging option for older employees

Dear Reader:

I am writing this letter to explain an income averaging option that may be available to some of your older employees who are eligible, upon retirement or other separation from service, for lump-sum distributions from your profit-sharing plan.

Under this income averaging option, lump-sum distributions paid to certain older employees may be eligible for special tax treatment. If a retiring employee's entire balance in your profit-sharing plan is distributed to the employee within one tax year (the employee's tax year, not the company's tax year) because of his or her separation from service under your company's retirement program, the distribution qualifies as a lump-sum distribution.

Retiring employees who reached age 50 before '86, that is, employees who turned 59-1/2 before '95, may elect ten-year averaging on the entire amount of the taxable portion of the distribution. Or, they can make this ten-year election on that portion of the distribution that isn't eligible for capital gain treatment (that is, the portion of the distribution attributable to post-'73 participation in the plan), with the portion eligible for capital gain treatment taxed at a flat 20% rate.

Ten-year averaging treats the lump sum distribution as if it were received over ten years. Before '74, lump sum distributions were taxed as capital gains, and this treatment continues for that portion of a distribution that is attributable to pre-'74 participation in the plan.

Not all employees who are eligible for ten-year averaging may benefit from having their lump sum distribution taxed under this method. That is because if an employee chooses the ten-year averaging method, the tax on the portion of the lump sum distribution that is not eligible for taxation at the capital gains rate will be taxed at special 1986 tax rates. These '86 rates may be higher than the income tax rates currently in effect. Thus, the benefits of averaging may be offset, at least in part, by higher tax rates being imposed on the averaged portions of the lump sum distribution.

The employee's individual circumstances will dictate whether the employee should elect ten-year averaging for his lump-sum distribution, if applicable.

You must use the greatest care in explaining this ten-year averaging option and its tax consequence to your older employees. They should also be made aware of their option to roll over tax-free the lump sum distribution to an IRA in order to further defer the tax on the lump-sum. These are major, once-in-a-lifetime decisions for your older employees, and you will want to guard against the possibility that an employee who misunderstands and makes the “wrong” decision for him or her will seek to hold you legally responsible.

We would be happy to discuss these important options in greater detail, or to prepare a detailed analysis of these rules. Please give us a call.