Deadline Nears for Averaging on Pension

Because of a production error, this story did not run in its entirety in some editions of the Nov. 26 paper.

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If you’re a retiree or plan to leave your job soon, now may be the last chance to take your “lumps” and avoid a tax beating.

A lesser-known tax break, known as five-year averaging, can provide significant savings on lump-sum distributions from qualified employer pension plans, though it’s set to expire Dec. 31. (A more restrictive 10-year averaging option still will be available.)

This complicated tax strategy, repealed by Congress in 1996, lets certain individuals cash out of their 401(k), profit-sharing program or employee stock options, for instance, and be taxed as if the sum was spread over five years, rather than in one lump.

Of course, you still pay the entire tax bill for the year the money is withdrawn, but the calculations used through averaging usually result in a much lower tax rate.

On a lump-sum payout of $300,000, for example, an individual might pay as much as $118,800 in federal income tax without averaging, using the highest tax bracket, according to calculations from the Institute of Certified Financial Planners, a Denver-based trade group. By using five-year averaging, the maximum tax cost for 1999 would be around $67,250.

However, not everyone can take advantage of this tax break. You must be at least 59 1/2 years old and have participated in the pension plan for at least five years, or have received the distribution as an heir from an employee who died.

The entire account must be withdrawn; partial withdrawals don’t qualify. Also, if you receive more than one lump sum during the year, you must use the averaging method on all of them, or else none of them.

Generally, you can use averaging only once in a lifetime, unless you’ve used it before 1987.

While financial advisors extol the benefits of five-year averaging, they’re quick to caution that not everyone should opt for a lump-sum payout to begin with.

“It’s only good for people who really need the money,” said Edward A. Slott, an accountant from Rockville Centre, N.Y., who publishes a weekly newsletter on tax and estate planning. “If you need the money and feel a lump-sum distribution is right for you, five-year averaging may be your only option.” (Next year, such distributions will be taxed as income or as a capital gain, he noted.)

The institute agreed.

“Unless you plan to use it to pay for a business you want to start or to cover a financial emergency, for example, you’re better off letting the money continue to compound tax deferred.”

That may mean leaving the money where it is or rolling it over into another qualified retirement account, such as an individual retirement account. You may want to liquidate it later on, when you really need the money or your tax rate is lower, or have the payments from the account spread out over many years like an annuity.

Those who were born before 1936 may qualify to use either five-year or 10-year averaging. The latter will be around after the 1999 tax year, though the 10-year method may not necessarily be the best approach, financial advisors caution.

If you qualify for both methods this year, you’ll need to run the numbers or consult a knowledgeable tax advisor who can prepare a complete spreadsheet for you.

Also, check out Internal Revenue Service publications 575 (Pension and Annuity Income) and 939 (General Rule for Pensions and Annuities), as well as Form 4972 (Tax on Lump-Sum Distributions).