Income Averaging for Retirees: Rules and Alternatives

Income averaging was a tax provision that allowed individuals with fluctuating income to smooth their tax liability by averaging their income over a period of years. This method was designed to prevent taxpayers from being pushed into a much higher tax bracket in a single high-income year. This general provision, however, is no longer available to most people, including retirees. The option was eliminated for the general public as part of a major overhaul of the U.S. tax system, and the specific mechanism of general income averaging is now a feature of past tax law for most individuals.

The Repeal of General Income Averaging

The ability for most taxpayers to use income averaging was eliminated by the Tax Reform Act of 1986. This legislation reshaped the federal income tax system, and the repeal of income averaging was part of its simplification goals. The primary reason for this change was the simultaneous flattening of the tax brackets, which reduced the potential for a single year of high income to create a disproportionate tax burden.

Consequently, a typical retiree today cannot use this method to lower their taxes based on income fluctuations from sources like IRA withdrawals or investment gains. The elimination of this provision means that retirees must look to other strategies to manage their tax liability from year to year.

Special Averaging for Lump-Sum Retirement Distributions

A specific exception to the repeal of income averaging exists for certain retirees who take a lump-sum distribution from a qualified retirement plan. This special treatment is only available to individuals born before January 2, 1936. A qualifying lump-sum distribution involves receiving the entire balance from a pension, 401(k), or other qualified plan within a single tax year due to an event like reaching age 59½ or separation from service.

For those who meet the age requirement, there are two potential calculation methods. The first is a 10-year averaging method, where the tax on the lump sum is calculated as if the money were received over a 10-year period, separate from the taxpayer’s other income. This calculation uses the 1986 tax rates. The second option allows the taxpayer to treat the portion of the distribution attributable to pre-1974 participation in the plan as a long-term capital gain, taxed at a 20% rate.

To elect this special tax treatment, the individual must file Form 4972, Tax on Lump-Sum Distributions, with their tax return. The necessary information for completing this form, such as the gross distribution amount, the ordinary income portion, and any capital gain portion, is provided by the plan administrator on Form 1099-R.

Income Averaging for Farmers and Fishermen

Another specific exception to the general repeal of income averaging is available to individuals in a farming or fishing business. This provision acknowledges the inherent volatility of incomes in these professions, which can be subject to significant fluctuations due to weather, commodity prices, and other external factors. To qualify, an individual’s main business must be farming or fishing, as defined by the IRS.

This rule allows qualifying individuals to average all or part of their current year’s farm or fishing income by spreading it over the previous three years. This is accomplished by using Schedule J, Income Averaging for Farmers and Fishermen, which is attached to their Form 1040. By shifting income from a high-income year to lower-income prior years, these individuals can often achieve a lower overall tax liability.

The calculation on Schedule J involves taking the elected farm or fishing income from the current year and allocating one-third of it to each of the three prior tax years. The tax for the current year is then recalculated based on this lower income figure.

Tax-Smoothing Strategies for Retirees

Since formal income averaging is not an option for most retirees, managing tax liability requires proactive planning through various tax-smoothing strategies. The goal is to control taxable income from year to year to avoid spikes that push you into higher tax brackets. This involves carefully orchestrating when and how you draw money from your retirement assets.

A foundational strategy is to establish systematic withdrawals from retirement accounts like traditional IRAs or 401(k)s. Instead of taking large, irregular distributions as needs arise, planning for relatively consistent annual withdrawals can keep your income stable. This approach helps prevent a single large withdrawal for a major purchase from creating an unusually high tax bill in one year.

Another strategy involves the staged conversion of funds from a traditional IRA to a Roth IRA. A Roth conversion is a taxable event, so converting a large account all at once can result in a substantial tax liability. By converting smaller amounts over several years, you can spread that tax impact out, allowing you to fill up lower tax brackets each year with the converted income.

Timing the sale of appreciated assets in your taxable brokerage accounts is another method for smoothing income. If you anticipate a year with lower-than-usual income, perhaps before you begin taking Social Security or required minimum distributions (RMDs), it could be an opportune time to sell assets and realize capital gains at a lower tax rate. Conversely, in a high-income year, you might harvest tax losses by selling investments that have decreased in value to offset other gains.

For retirees who are charitably inclined and over the age of 70½, a Qualified Charitable Distribution (QCD) is a useful tool. A QCD allows you to donate up to $108,000 in 2025 directly from your IRA to a qualified charity. This amount can count toward your RMD for the year but is excluded from your adjusted gross income (AGI), which can be more beneficial than taking the distribution and then claiming a charitable deduction.

An approach to consider involves coordinating withdrawals from different account types. Retirees often have three types of accounts: tax-deferred (like traditional IRAs), tax-free (like Roth IRAs), and taxable brokerage accounts. By strategically drawing from each type in different years, you can effectively create a custom tax outcome, such as pulling from a Roth IRA to avoid increasing your taxable income.