Income averaging is a federal tax code provision for people with widely varying income from one year to the next. It allows people who receive little income one year and huge income the next to reduce their tax liability by spreading out the tax bite on the huge sum over a three-year period. The 1986 Tax Reform Act abolished income averaging for all taxpayers except farmers, fishermen and certain qualifying retirees who cash out their retirement plans.
What Happens Now
Prior to the 1987 tax year, any taxpayer who experienced a large bulge in annual income such as from a huge work bonus or big sales commission, or a financial windfall such as from lottery jackpot winnings, could use income averaging to reduce his tax bill. Since 1987, according to FinancialDictionary.com, the federal tax code requires taxes on an extraordinary income bulge to be paid in full in the year the money was paid, regardless of whether this pushes the taxpayer into a higher tax-rate bracket. The major exceptions are for farmers and fishermen, who are still allowed to use income averaging.
Farmers and Fishermen
Income averaging for farmers and fishermen works like this: They take this year’s big income bulge and divide it into thirds. They recalculate their income taxes for this year and the preceding two years based on one-third of the income bulge being posted in each of the three years. According to HoneckOtoole.com, this effectively increases their taxable income for the preceding years while reducing it for the current year. Under the graduated income tax system, the tax rate applied to these revised annual income figures would increase, but by much less than if the entire income bulge were to be taxed this year. The net result is to lower the total tax owed on the income bulge.
Income Averaging and AMT
Farmers and fishermen who tried to use income averaging to offset an exceptionally good income year sometimes ran afoul of the Alternative Minimum Tax (AMT). The AMT is a parallel income tax system that doesn't recognize many of the exemptions and deductions of the regular income tax system. Taxpayers owe the higher of regular income tax or the AMT. But the reduced tax bills from income averaging put some farmers and fishermen into the clutches of the AMT, eliminating any tax savings from income averaging, states the University of Missouri Agricultural Extension Service. Congress corrected this situation in 2004 by specifying that AMT liability must be compared to the calculated regular tax liability, not the lesser tax liability after using income averaging.
Another Income Average
Another form of income averaging exists for certain people who close out a tax-deferred retirement plan such as a 401k or traditional individual retirement account by taking a large lump-sum distribution. According to SunTrust.com, people born before 1936, who have been in their tax-deferred retirement plan for at least five years and who take out the entire balance in their plan in a single distribution, may be able to use 10-year income averaging to spread the tax bite over a 10-year span. The IRS would assume the account balance was paid in 10 equal annual installments and set the annual tax liability accordingly.
Averaging in Tax Settlements
The Internal Revenue Service, at its option, may permit a delinquent taxpayer to use forward income averaging in a tax settlement to spread the back taxes out over the next three or more years, said the Roni Deutch Tax Advocates website. The IRS may permit forward averaging for delinquent taxpayers who are commissioned salespeople or self-employed people whose income is wholly at the mercy of the market for their trade. Permission to use forward income averaging is granted or denied on a case-by-case basis, depending on the IRS’ judgment call of whether current earnings or average earnings history better represents the taxpayer's earning capacity.