What it means
Most income tax systems are progressive, which means each additional dollar of income in a year is taxed at a higher rate than the one before. A lump sum, such as a retirement payout or a one-off settlement, can push a person into the top brackets for that year.
Forward averaging softens that effect by taxing the sum as though it had been earned evenly over a set number of years. The method does not delay the payment or hand the money over in instalments.
The full amount is received at once, but the tax is calculated using the lower brackets that would have applied to each slice. Think of it as a calculation rule rather than a cash arrangement.
Availability depends heavily on the country and the type of payment, and in many places the rules have been closed to new claimants or replaced by other reliefs. Anyone who might benefit should check with a tax adviser before relying on it.
A rule that was generous in the past may no longer exist at all. Related ideas exist elsewhere in tax.
Some systems allow farmers, authors and sportspeople with uneven earnings to average income over several years, which has the same aim of smoothing the effect of progressive rates. The details differ, but the principle is that bunching income into one year is penalised and spreading it out is rewarded.
For finance teams, forward averaging matters mainly when advising on severance packages, bonuses and retirement payouts. A good adviser will compare the tax on the lump sum with and without averaging, as well as with alternatives such as rolling the money into a pension.
The best answer depends on the person's other income and the rules in force at the time.
In practice
Real-world examples.
Example
A manager retiring from a manufacturing firm receives a $150,000 lump sum payout from her pension. Her adviser compares the tax with and without averaging and finds that, under the rules available to her, spreading the sum across several years of bands cuts the tax bill by thousands. She chooses the averaging election on her tax return.
Example
A consultant who has been paid $90,000 for a settlement on a long-running contract dispute asks his accountant whether the payment can be averaged. The accountant explains that the relief is not available for this type of payment in his country. He instead plans to spread other income into later years.
Example
A small family farm has a bumper year after selling a large crop in one go. The farmer uses an income averaging scheme to smooth the profit across several tax years and avoids paying the top rate on the whole amount.
Formula
Calculation
Tax with averaging = (Tax on lump sum divided by N years) x N
Suppose a person receives a $100,000 lump sum and the illustrative tax bands are 10% on the first $40,000 of a year's income and 30% on anything above that. Without averaging, the tax is 40,000 x 10% = $4,000, plus 60,000 x 30% = $18,000, giving $22,000.
With averaging over 5 years, each slice is 100,000 / 5 = $20,000, which falls entirely in the 10% band. Tax on one slice is 20,000 x 10% = $2,000, and across 5 slices the total is 2,000 x 5 = $10,000. The saving from averaging is 22,000 - 10,000 = $12,000.Case study
Seen in the real world.
Ashgrove Engineering is a fictional company that has agreed to pay a long-serving director a $240,000 retirement lump sum. The finance manager asked the company's tax adviser how the director would be taxed.
In this illustrative scenario, the adviser used the same assumed bands as above, 10% on the first $40,000 of a year's income and 30% on the rest. Taxed in one year, the lump sum would fall largely into the top band and produce a bill of 4,000 + (200,000 x 30%) = $64,000. Averaged over five years under an assumed relief, each slice of $48,000 would cost 4,000 + (8,000 x 30%) = $6,400 in tax, and the total would fall to 6,400 x 5 = $32,000.
The director kept the extra $32,000, and the company changed its retirement policy so that future payouts could be structured to use any available relief. The illustrative lesson is that how a lump sum is taxed can be worth as much as small changes in the headline amount.
Watch out
Common mistakes.
- Thinking that forward averaging spreads the cash payment over several years, when the money is paid at once and only the tax calculation is averaged.
- Assuming the relief is available everywhere and for every kind of lump sum, when it is limited by country, payment type and the person's circumstances.
- Ignoring other income, since averaging helps most when the slices fall into lower bands than the lump sum would in a single year.
Questions
People also ask.
Is forward averaging the same as income averaging?
They are close cousins, but forward averaging usually refers to spreading a single lump sum forward, while income averaging smooths earnings across years for people with uneven income.
Does forward averaging reduce tax in every case?
No, if the person already has low income or the bands are flat, the averaged tax may be the same as the ordinary tax.
Where should I check whether I can use it?
Ask a qualified tax adviser or read guidance from your tax authority, because rules change and many reliefs have been closed or replaced.
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