Taxes: Income Averaging

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Illustration by Fotolia/Stuart Miles
People who had volatile incomes were the main beneficiaries of income averaging.

EDITOR’S NOTE: The following text is relevant for historical purposes only. Although commercial fishermen and some farmers are still permitted to use income averaging, the 1986 tax reform act eliminated it for everyone else.

If your income increases significantly from one year to the next — particularly if the good year follows three lean ones — you may benefit from income averaging, which, in effect, allows you to spread out your taxable income over the years involved. Here’s how you qualify.

First, you must be a citizen or resident alien. Second, you may not average if you or your spouse provided less than 50% of your support during 1981, 1982, and 1983, unless (a) you were 25 or older at the close of 1984 and weren’t a full-time student during four of the taxable years after you reached 21; (b) more than 50% of your 1984 income came from work performed in 1981, 1982, and/or 1983; (c) your spouse’s earnings were less than 25% of your joint 1984 income and you were self-supporting in 1981, 1982, and 1983. Owner-employees and key employees may not average premature distributions from retirement plans. Publication 506 outlines other requirements and adjustments for income averaging.

Once you’ve determined that you qualify to attempt to income average, you’ll need to figure out if it’s actually to your advantage to average. Follow the instructions on Schedule G very carefully, bearing in mind that this is one of the most mistake-ridden forms submitted to the IRS. If you do it correctly, buy yourself a treat!