Understanding Forward Averaging

by Investing School on February 24, 2013

One of the ways you can opt to have to have a lump-sum distribution from a qualified pension and profit-sharing plan is called “forward averaging.” This method is a special tax treatment which is very different from the “income averaging” that was used many years ago.

The rules are complex, but essentially, this lump-sum distribution is one in which your whole balance is disbursed to you, or your beneficiaries at one time. This might occur because of your death, you have reached the age of 59 ½ or you have become disabled and are self-employed.

If you qualify for this kind of lump-sum tax treatment you have special tax rates that are made available to you, allowing you to save a considerable sum when compared to the normal taxes assessed in a lump-sum payout. You do this by averaging the taxes that should be paid on your qualified distribution over a 10-year period.

The ten year averaging method is available to anyone who has reached the age of 50 before January 1, 1986. The tax rate used, however, will be those from 1986, which happen to be higher than they are right now. Once this payment treatment is chosen, all distributions in the future must use the same treatment and it can only be used once in your lifetime.

Formulas for calculating how much you would receive under a forward averaging treatment are available online. There are several other options for how you want your assets distributed, and it is worth comparing them to find out which offers you the best results.

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