Is Income Averaging Still Allowed by the IRS?

The short answer is a resounding no. Income averaging, once a valuable tool for taxpayers experiencing significant fluctuations in income, was repealed for tax years beginning after December 31, 1986. This means that for the vast majority of taxpayers today, the concept of income averaging is relegated to historical tax trivia.

A Look Back: What Was Income Averaging?

Income averaging, in its heyday, allowed taxpayers to reduce their tax liability by smoothing out spikes in income. It was particularly beneficial for individuals like artists, writers, athletes, and farmers whose earnings could vary dramatically from year to year. The idea was simple: if your income in a given year was significantly higher than your average income over the previous three years (the “base period”), you could spread the excess income over those years, potentially lowering your overall tax bill.

Imagine a struggling musician who finally lands a record deal. Suddenly, they go from earning next to nothing to making a substantial income. Without income averaging, they’d be taxed at a much higher rate on that single year’s earnings. Income averaging softened that blow.

The repeal of income averaging was part of the Tax Reform Act of 1986, a sweeping overhaul of the US tax code. While the act brought many changes intended to simplify the tax system and lower overall rates, it also eliminated several deductions and credits, including income averaging. The rationale was that lower marginal tax rates made income averaging less necessary.

Who Can Still Use Income Averaging? (A Very Specific Exception)

While income averaging is generally unavailable, there is one very specific exception: qualifying farmers and fishermen. They are permitted to use a modified version of income averaging, not the old method that was repealed for everyone else.

This special provision, found on Schedule J (Form 1040), Income Averaging for Farmers and Fishermen, allows these taxpayers to elect to average all or part of their elected farm income (or fishing income) over the prior three years. This can be advantageous in years where their income significantly exceeds their average income from previous years.

The calculation involves allocating a portion of the current year’s farm or fishing income to each of the three preceding tax years. This can result in a lower tax liability because it potentially moves income out of a higher tax bracket and into lower ones.

However, it’s crucial to understand that this is not the same income averaging that existed before 1987. The rules are different, and the eligibility is extremely limited.

Why Was Income Averaging Repealed?

Several factors contributed to the repeal of general income averaging:

• Tax Rate Reduction: The Tax Reform Act of 1986 significantly lowered individual income tax rates. The justification was that with lower rates, the need for income averaging diminished.
• Simplification: Eliminating income averaging simplified the tax code by removing a complex calculation and form.
• Revenue Considerations: Repealing deductions and credits, including income averaging, helped offset the revenue lost from the tax rate reductions.

While the repeal aimed for simplification, it undoubtedly impacted certain taxpayers who relied on income averaging to manage their tax liability.

The Modern Tax Landscape: Alternatives to Income Averaging

While broad income averaging is no longer available, several other strategies can help taxpayers manage income fluctuations and minimize their tax burden:

• Retirement Savings: Contributing to retirement accounts, such as 401(k)s and IRAs, allows you to defer income and potentially reduce your current tax liability. This is especially beneficial in high-income years.
• Tax Loss Harvesting: Selling investments that have lost value can generate capital losses, which can offset capital gains and potentially reduce your overall tax liability.
• Estimated Taxes: Making timely estimated tax payments throughout the year can help avoid penalties and ensure you’re meeting your tax obligations.
• Business Expenses: If you’re self-employed or own a business, carefully tracking and deducting legitimate business expenses can significantly reduce your taxable income.
• Maximize Deductions and Credits: Staying informed about available deductions and credits, such as the standard deduction, itemized deductions (if they exceed the standard deduction), and various tax credits, can help minimize your tax bill.

These strategies, while not a direct replacement for income averaging, can provide valuable tax relief and help you manage your finances effectively.

Schedule J: A Closer Look at Income Averaging for Farmers and Fishermen

If you’re a qualifying farmer or fisherman considering using Schedule J, it’s essential to understand the specific requirements and calculations:

• Eligibility: You must be engaged in a farming or fishing business.
• Elected Farm Income: You can choose to average all or a portion of your elected farm income (or fishing income). This is the income you want to spread over the previous three years.
• Allocation: You allocate one-third of the elected farm income to each of the three prior tax years.
• Recomputation: You recompute your tax liability for each of those three years, including the allocated farm income.
• Tax Savings: The tax savings (if any) are the difference between the original tax liability for those years and the recomputed tax liability.
• Form 1040: The total tax savings are reported on Form 1040.

It’s strongly recommended that farmers and fishermen consult with a qualified tax professional to determine if using Schedule J is beneficial in their specific situation. The calculations can be complex, and understanding the rules is crucial to avoid errors.

Frequently Asked Questions (FAQs)

1. What exactly does it mean to “average” income?

Income averaging, in its historical context, meant spreading a portion of unusually high income over previous years with lower income. This could potentially lower your overall tax burden because it could move income from a higher tax bracket in the current year to lower tax brackets in prior years. Think of it like spreading peanut butter thinly across multiple slices of bread instead of piling it all on one slice.

2. Why was income averaging more important before the 1986 Tax Reform Act?

Prior to the 1986 Act, marginal tax rates were significantly higher and more progressive. This meant that even a moderate increase in income could push you into a substantially higher tax bracket. Income averaging provided a way to mitigate the impact of these high rates on fluctuating incomes.

3. Are there any other professions besides farming and fishing that can still use income averaging?

No. The only current exception to the repeal of income averaging applies to qualifying farmers and fishermen. No other profession or individual can utilize any form of income averaging with the IRS.

4. What qualifies someone as a “farmer” for the purposes of Schedule J?

A farmer is defined as someone who cultivates, operates, or manages a farm for profit, either as an owner or tenant. This includes activities like raising crops, livestock, and other agricultural products.

5. What qualifies someone as a “fisherman” for the purposes of Schedule J?

A fisherman is defined as someone who commercially harvests fish, shellfish, or other aquatic animals for sale. This doesn’t typically include recreational fishing.

6. If I have a side business in addition to my regular job, can I use Schedule J if my side business is farming?

Potentially, but only the income from the farming activity can be considered for income averaging on Schedule J. Your income from your regular job cannot be included in the calculation.

7. Does income averaging affect my Social Security or Medicare taxes?

No, income averaging, even when used by farmers and fishermen on Schedule J, only affects your income tax liability. It does not change the amount of Social Security or Medicare taxes you owe.

8. Can I amend a prior-year tax return to use income averaging if I meet the requirements for farmers and fishermen?

Yes, you can generally amend prior-year tax returns within the statute of limitations (usually three years from the date you filed the original return or two years from the date you paid the tax, whichever is later) to claim income averaging if you were eligible but didn’t initially use it.

9. What happens if I’ve already filed my taxes and then realize I qualify for Schedule J?

You can file an amended tax return (Form 1040-X) to claim the benefits of income averaging as a farmer or fisherman.

10. Where can I find Schedule J (Form 1040) and instructions?

You can download Schedule J (Form 1040) and its instructions from the IRS website (www.irs.gov). Search for “Schedule J” in the search bar.

11. Are there any downsides to using Schedule J, even if it lowers my taxes?

While it’s generally beneficial if it reduces your tax liability, Schedule J can add complexity to your tax return. It also requires recomputing your tax liability for previous years, which can be time-consuming. It’s best to assess whether the tax savings outweigh the added complexity.

12. Should I consult a tax professional before using Schedule J?

Absolutely. Given the complexity of the calculations and eligibility requirements for Schedule J, consulting with a qualified tax professional is highly recommended, especially if you are unsure about any aspect of the process. A tax professional can help you determine if income averaging is beneficial for your specific situation and ensure that you are complying with all applicable tax laws and regulations.