Forward Averaging

What Is Forward Averaging?

Forward averaging involves treating lump-sum retirement-plan distributions as if they were spread out over a longer period of time. Forward averaging is available only to qualified plan participants who were born before 1936 and meet certain requirements.

How Forward Averaging Works

Forward averaging is a technique for lowering the tax rate on the present year’s income. Without forward averaging, a lump-sum distribution from a retirement plan may push a taxpayer into a higher tax bracket. However, forward averaging allows taxpayers to spread that lump-sum retirement income over several prior years, typically either five or ten years. Then, the tax rate is calculated based on an average of those prior years.

The lump-sum distribution is treated for tax purposes as though it had been spread out evenly over five or ten years. Because the taxpayer would most likely have a lower income in those prior years, forward averaging generally results in the distributions from a retirement plan being taxed at a lower rate than the individual's ordinary tax rate.

Requirements for Forward Averaging

Forward averaging is available only to a certain segment of taxpayers. Individuals must be born before Jan. 2, 1936, to qualify for current ten-year forward averaging rules set by the Internal Revenue Service (IRS). Also, the individual must be receiving qualified plan distributions in the form of a lump-sum distribution.

According to the IRS, a lump-sum distribution is one that is paid due to the plan participant’s death (after the participant reaches age 59½) because the participant separates from service or after they, if self-employed, become totally and permanently disabled. Also, the entire balance of the retirement plan must be distributed to the participant within one calendar year, and the participant must have been enrolled in the retirement plan for at least five years prior to distribution. The five-year income averaging was repealed for taxable years beginning on or after Jan. 1, 2000.

Advantages and Disadvantages of Forward Averaging

Forward averaging may provide tax benefits in certain situations. By spreading a lump-sum distribution over a number of years, individuals are generally able to remain in a lower tax bracket. However, in some cases, there may be drawbacks to forward averaging. The current ten-year forward averaging policy uses a calculation based on 1986 tax rates.

The top bracket in 1986 was taxed at 50%, so high earners may not benefit from forward averaging. Also, by taking a lump-sum distribution and applying forward averaging, an individual forgoes the option to roll those funds into a tax-deferred account.