7.3 Lump-Sum Options If You Were Born Before January 2, 1936

If you expect to receive a lump-sum distribution eligible for averaging (7.2), you must decide whether to pay tax currently using the averaging method (and possibly the 20% capital gain method for pre-1974 participation), or to defer tax by making a tax-free rollover (7.7). If you receive more than one lump sum during the year, you must make the same choice for all of them; you may not roll over one lump sum and claim averaging for another.

If you do not instruct the payer to make a direct rollover (7.8), 80% of the taxable distribution will be paid to you; a 20% tax will be withheld. If you later decide to make a rollover, you have 60 days from the time of receiving the distribution to do so (7.8). However, to avoid tax on the entire distribution, you will have to include in the rollover an amount equal to the withheld tax. Withholding is discussed further at 7.8 and 26.11. Ordinary income tax rates apply to the amount not rolled over, unless you are eligible for averaging or the 20% capital gain method.

Planning Reminder

Once in a Lifetime Election

You are allowed to elect averaging only once as a plan participant after 1986. If you were born before January 2, 1936, have not previously elected averaging, and elect averaging for a distribution received in 2012, you will not be able to claim averaging again if you join another company and receive a lump-sum distribution from the new employer.

Even if you are barred from electing averaging for a lump sum from your own plan, you can make the election as a beneficiary of a deceased plan participant born before January 2, 1936.

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Conduit IRA preserves averaging option.

If you are changing jobs, a direct rollover or personal rollover may be made to a traditional IRA or a qualified plan of your new employer. However, if the distribution is rolled over to a traditional IRA, you lose the right to claim averaging in the future for those assets unless the IRA is a “conduit IRA” that serves as a holding account until a later rollover may be made to another employer’s plan. As long as the distribution and earnings on the distribution are the only assets in the conduit IRA, a rollover may later be made from the conduit IRA to a new employer’s plan, from which a lump-sum distribution eligible for averaging may later be received. Distributions from a traditional IRA are taxable as ordinary income.

If you plan to continue working and expect to receive another lump sum in the future, you may not claim averaging for the current lump sum and also for the later distribution. Averaging may be claimed only once as a plan participant after 1986.

An IRA rollover cannot be revoked to claim averaging.

If you make a rollover to an IRA, you cannot change your mind and cancel the IRA account in order to apply special averaging. The rollover election is irrevocable, according to an IRS regulation that has been upheld by the Tax Court. If an IRA rollover account is revoked, the entire distribution is taxable as ordinary income, and a 10% penalty may be imposed if the recipient is under age 59½ (7.15).

Disqualification of retirement plan.

If you receive a lump-sum distribution from a plan that loses its exempt status, the IRS may argue that the distribution does not qualify for lump-sum treatment. Under the IRS position, you may not roll over the distribution to an IRA or elect special averaging. The Tax Court previously took the position that if the plan qualified when contributions were made, an allocable portion of the distribution was a qualified lump sum. However, the majority of appeals courts that reviewed Tax Court decisions on this issue supported the IRS position. In response, the Tax Court reversed its position and adopted the harsher IRS approach: no part of the distribution qualifies for rollover or averaging if the plan loses its exempt status.