Forums Support Library EPT – Estate Planning Tools Lump Sum Distributions

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    • Kathleen Reynolds
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      Calculates the tax due, the amount remaining, and the effective tax rate on a lump sum distribution from a qualified pension or profit sharing plan if the lump sum qualifies for ten-year averaging at the 1986 rate, or five-year averaging at the current year’s rate (for years prior to 2000).

      Lump sum distributions from a qualified pension of profit sharing plan must be included in reportable gross income and taxed at ordinary rates. For example, assume an individual has $100,000 of taxable income in 1993 and files jointly with two exemptions with the applicable tax being $23,529. If an additional $100,000 in pension payments is received by the individual, the tax on the total income would be $58,205. The additional $100,000 cost $34,676 in additional tax ($58,205 minus $23,529). However, if the individual received a lump sum of $100,000 that qualified for special five-year averaging, the tax on the lump sum would be $15,000 or a difference of $19,676 ($34,676 minus $15,000).

      The lump sum qualifies for this one-time election of five-year averaging only if all of the following requirements are met:

      • The sum is taken prior to the year 2000.
      • The sum is received after the recipient turned 59½ years of age.
      • The sum is paid within one tax year.
      • The sum is the entire distribution of the employee’s benefit in the plan. (All pension plans maintained by an employee are considered a single plan. This also applies for profit sharing and stock bonus plans.)
      • The sum is payable for one of the following reasons:
        1. the participant has died
        2. the participant has attained age 59½
        3. the employment of a non-self employed individual has been terminated;
        4. a self-employed individual has become disabled.
      • The sum is distributed from a qualified plan (not an IRA or 403(b) tax-deferred annuity).
      • The employee participated in the plan for at least five years prior to the distribution (this requirement does not apply to a death benefit).

      If the lump sum distribution meets all of the above qualifications, it is eligible for five-year averaging. In some cases, certain tax benefits available before 1987 for lump sum distributions have been grandfathered for existing participants. Such participants may choose to treat the amount accumulated prior to 1974 as a long-term capital gain. If the participant was in the plan prior to 1974, the distribution is divided into two amounts, a pre-1974 amount and a post-1975 amount. The pre-1974 amount is taxed at a 20% rate (the capital gain maximum). This capital gain treatment is phased out in the following manner: only 95% of the pre-1974 amount is eligible in 1988, 75% is eligible in 1989, 50% in 1990, and 25% in 1991.

      This capital gain treatment is not required. The entire distribution can be treated under current five-year averaging if the participant so chooses. Any part of the distribution that does not qualify for capital gains treatment can (if it does) qualify for five year averaging.

      From 1974 through 1986, ten-year averaging was applied to lump sum distributions. This practice is still available for individuals who attained age 50 before January 1, 1986. Such individuals who receive a distribution after 1986 may use ten-year averaging with the 1986 tax rates instead of five-year averaging with current rates. This practice is recommended if it results in lower taxes.

      Lump Sum Screenshot

      Entering Data

      • Current Year Enter the current year. The program handles years from 1987 through the current year.
      • Taxable Amount of Lump Sum Distributions Enter the taxable amount of the lump sum distribution.

      Lump Sum Summary

      Lump Sum Table Screenshot

      Lump Sum Graph Screenshot

      The program shows the amount of tax due, the amount remaining, and the effective tax rate on a lump sum distribution. To calculate these values, the calculation first subtracts a “minimum distribution allowance” from the taxable amount specified at the Taxable Amount of Lump Sum Distribution entry field. The minimum distribution allowance is the lesser of (a) $10,000 or (b) one-half of the total taxable amount in excess of $20,000. (The minimum distribution allowance does not apply if the taxable amount is $70,000 or more.) The calculation then divides the remaining taxable amount by five and determines a separate tax on this portion based on the single taxpayer rate without any deductions or exclusions. The resulting tax is then multiplied by five. Results are shown for ten-year averaging, five-year averaging (last year’s tax rate), and five-year averaging (the current year’s tax rate).

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