When Is NUA Treatment the Best Choice for You?
In general, the NUA strategy makes the most sense for individuals who have a large amount of NUA and a relatively small cost basis. However, whether it's right for you depends on many variables, including your age, your estate planning goals, and anticipated tax rates. In some cases, rolling your distribution over to an IRA may be the better choice.
And, if you were born before 1936, two other special tax rules (described below) might also apply to your lump-sum payment, potentially making a taxable distribution your best option.
What is the 10-year averaging method?
The 10-year averaging method is a special formula for calculating the federal income tax due on the ordinary income part of a lump-sum distribution from a qualified employer-sponsored retirement plan. You pay this tax only once--the year in which you receive the distribution; it's not paid over the next 10 years.
Essentially, you calculate the tax on one-tenth of the taxable portion of your distribution, using 1986 income tax rates for single filers. You then multiply this tax by 10 to determine the income tax due on your lump-sum distribution.
Because your adjusted gross income (AGI) doesn't include distributions calculated according to the 10-year averaging method, AGI-sensitive tax breaks won't be adversely affected by the income from your lump-sum distribution.
What is the capital gain election for pre-1974 participation?
Capital gain treatment applies only to the taxable part of a lump-sum distribution resulting from participation in a qualified retirement plan before 1974. The amount treated as capital gain, reported on your Form 1099-R, is taxed at 20%, which may be lower than your ordinary marginal income tax rate.
If you make the capital gain election, you can either treat the remainder of the taxable distribution (i.e., the portion representing participation from 1974 to the present) as ordinary income, or use the 10-year averaging method for that portion.
What are the eligibility requirements for the 10-year averaging method and the special capital gains tax treatment?
To qualify for 10-year averaging and/or the special capital gains tax treatment, the following requirements apply to your lump-sum payment:
- The plan participant (whether alive or dead in the year of distribution) must have been born before 1936.
- The plan participant must have received the distribution after belonging to the plan for at least 5 tax years. Exception: the 5-year rule doesn't apply if the distribution was paid because of the plan participant's death.
- The plan participant (or the beneficiary) must elect to use the 10-year or capital gains tax treatment (and this election can generally be made only once). So, if you elected 5-year or 10-year averaging or the capital gains tax treatment in the past, you probably don't qualify for special tax treatment again. However, if you made the election before 1987 and were under age 59½ at that time, you can make the 10-year or capital gain election once again if you meet all of the other requirements.
The rules for 10-year averaging and the capital gains election are complicated, and other significant restrictions apply. You should consult your financial professional to decide which option (or combination of options) makes the most sense for your particular situation.