Simplified and Special Averaging Methods

Simplified Method

The simplified method may be used to compute the taxable portion of a pension or annuity with a starting date after July1, 1986. The pension or annuity must meet the following three conditions:

• The payments are for either the annuitant's life or the joint lives of the annuitant and a beneficiary;
• The payments must be from a qualified pension, profit-sharing, or stock bonus plan; a qualified employee annuity plan; or a tax-sheltered annuity; and
• The annuitant must be under 75 years of age when the payments begin, or if 75 or older, there must be fewer than five years of guaranteed payments.

Pension and annuity income is fully taxable if the taxpayer did not contribute after-tax money to the cost of the pension or annuity or, in some cases, if the taxpayer has recovered his entire cost  in previous years. Use of the simplified method for computing the taxable portion of a pension or annuity is generally mandatory for pensions starting after November 18, 1996. 

SPECIAL AVERAGING METHODS

When a taxpayer receives a lump-sum distribution he has some choices to make. He may choose to roll over all or part of the distribution into a traditional IRA or other eligible retirement plan within 60 days. Any amount the taxpayer rolls over isn't currently taxable.

Ten-Year Averaging

Ten-year averaging may be used to compute the tax on a lump-sum distribution only if the emplyee or self-employed person

1. Was born before January 1, 1936, and
2. Was an active participant in a qualified plan for at least five full years (except in the case of death) before the year of the distribution. If the distribution was made due to the death of the plan participant, the beneficiary may use special 10-year averaging if the distribution otherwise qualifies.

Qualified higher education expenses

The expenses must be paid for the taxpayer, his spouse, or the child or grandchild of the taxpayer or spouse.

Qualified first-time home-buying expenses

For the purpose of exception 9, are any costs of acquiring or construction a principal residence for a firs-time homebuyer. The term first-time homebuyer is misleading; what it really means is someone who has not owned a home during the two-year period prior to the acquisition of the home to which this exception applies.

The distribution must be used to pay qualified expenses within 120 days of the date of distribution. The expenses must be paid for the taxpayer, his spouse, child, or grandchild, or parent or grandparent.

SIMPLE Distributions

Early withdrawals from a SIMPLE IRA are generally subject to the usual 10-percent penalty, but a 25  percent penalty applies to withdrawals made during the first two years in which an employee participates in the plan.

Rollovers can be made from one SIMPLE IRA to another. Rollovers to traditional IRAs are permitted at the end of two years of participation in the plan.

See: Self-employment income