What Is the Lump Sum Election Method?

The lump sum election method is a special tax calculation for certain retirement plan distributions that may result in a lower tax liability compared to treating the payout as ordinary income. This tax treatment is not available to everyone and is governed by a strict set of regulations designed for a specific group of individuals. The method involves distinct calculations that separate the distribution into different components for tax purposes.

Eligibility for the Lump Sum Election

The primary requirement for using the lump sum election method relates to the plan participant’s age. To qualify, the plan participant on whose behalf the distribution is made must have been born before January 2, 1936. If this birth date requirement is not met, this special tax treatment cannot be used.

The distribution itself must qualify as a lump-sum distribution, meaning the entire balance from an employer’s qualified plan is paid out within a single tax year. Qualified plans include pension, profit-sharing, or stock bonus plans. The payout must be the total amount due from all of the employer’s similar plans.

The distribution must also be made for a specific reason. These reasons include:

• The plan participant separates from service with the employer.
• The distribution occurs after the participant reaches age 59½.
• The payment is made to a beneficiary after the participant’s death.
• The participant was self-employed and the distribution is made after age 59½ or due to total and permanent disability.

A minimum participation requirement also applies. The plan participant must have been active in the plan for at least five full tax years before the year of the distribution. An exception to this five-year rule exists if the distribution is paid to a beneficiary following the participant’s death.

Calculating the Tax Using Special Methods

Two distinct methods are available for calculating the tax on a qualified lump-sum distribution: a capital gain treatment and a 10-year averaging method. A taxpayer may use one or both of these options depending on their distribution. These calculations are performed separately from the taxpayer’s other income.

The capital gain treatment applies only to the portion of the distribution from plan participation before 1974. This amount is reported in Box 3 of Form 1099-R. Taxpayers can elect to treat this portion as a long-term capital gain, which is taxed at a 20% rate. This can be advantageous compared to having it taxed at higher ordinary income rates.

The 10-year averaging method applies to the ordinary income portion of the distribution. This portion is the total taxable amount minus any part treated as a capital gain. The calculation is a hypothetical one designed to smooth out the tax impact, where the tax is figured as if the money were received over a 10-year period, even though it is paid in the current year.

The 10-year averaging calculation begins with the ordinary income portion of the distribution, from which a Minimum Distribution Allowance may be subtracted. The result is divided by 10, and tax is calculated on this smaller amount using 1986 tax rates for a single individual. This calculated tax is then multiplied by 10 to determine the total tax due on the ordinary income portion.

Required Information for Form 4972

To use the lump sum election, taxpayers must complete IRS Form 4972, Tax on Lump-Sum Distributions. The official and most current version of this form and its instructions should be obtained from the IRS website. Using an outdated form can lead to incorrect calculations and potential issues with the IRS.

Information to complete Form 4972 comes from Form 1099-R, which is provided by the plan administrator. The figures needed from Form 1099-R include Box 1 (Gross distribution), Box 2a (Taxable amount), and Box 3 (Capital gain part). These amounts are transferred directly to the corresponding lines on Form 4972.

The structure of Form 4972 guides the taxpayer through the calculation. Part I confirms eligibility, Part II is used for the 20% capital gain election, and Part III is for the 10-year averaging calculation. The form’s instructions provide the specific 1986 tax rate schedule needed for this calculation.

How to File Form 4972

Once completed, Form 4972 must be attached to the taxpayer’s main income tax return for the year the distribution was received. It should be filed with Form 1040, Form 1040-SR, or Form 1040-NR.

The final tax liability from Form 4972 is transferred to the taxpayer’s primary tax form. This total tax is reported on Schedule 2 (Form 1040), Additional Taxes, and then included on the main Form 1040.

The tax on the lump-sum distribution is paid along with the rest of the individual’s income tax. There is no separate payment voucher or deadline for this amount, as it is integrated into the total tax due or refund. If a taxpayer was eligible but did not claim this treatment, they can file an amended return within three years of the original filing date to submit Form 4972 and claim a refund.