Equality or simplicity: The income taxation of retirement plan distributions

Abstract

The income tax rules concerning distributions from qualified retirement plans are considered by most to be a maze of rules defying logic. Some distributions qualify for a variety of special federal income tax treatments while others are taxed as ordinary income.In 1974, Congress proposed to equalize the total tax of taxpayers who receive distributions from retirement plans regardless of whether the distributions are received in a lump sum or as an annuity. The legislation provided a ten-year forward averaging rule for determining the tax to taxpayers receiving a lump sum distribution from a qualified pension plan. This rule was subsequently modified to five-year forward averaging in 1986.Congress recently repealed the five-year averaging rule and enacted a simplified method for determining an annuity's return on investment. The justification for the new legislation was “simplicity” rather than the original purpose — to prevent the bunching of taxable income into a single year as results from a lump sum distribution.Although Congress set out to equalize the income tax across the two forms of distributions, after two decades of tinkering, the law penalizes taxpayers who elect to receive the deferred compensation in the form of a lump sum distribution and, thereby, encourages the withdrawal of retirement assets over the life of the retiree all in the name of simplification. However, the result of the changes in the law is neither equality nor simplicity.

Citation

Curatola, A.P., Trewin, J. and Walters-York, L.M. (2001), "Equality or simplicity: The income taxation of retirement plan distributions", Advances in Taxation (Advances in Taxation, Vol. 13), Emerald Group Publishing Limited, Leeds, pp. 49-68. https://doi.org/10.1016/S1058-7497(01)13006-1