How to Use Income Averaging on Your Taxes

Income averaging is a federal tax provision that since 1987 focuses solely on two select groups of taxpayers, farmers and fishermen, both of which exhibit income volatility as a common characteristic. The intent of the tax provision is to reduce qualifying individuals' tax liability for the current year by averaging income between the current and past three years and calculate a tax bill using tax tables for all four years. Savings result as previous year tax tables often calculate taxes at a lower rate.

Confirm Eligibility

Read through the Definitions section of Schedule J for Form 1040 to ensure you qualify to use income averaging. Start by defining your filing category. Basic eligibility requirements state that you must be filing as an individual, co-owner in a partnership or a shareholder in an S Corporation. Income averaging does not apply to corporations, partnerships, S corporations, estates or trusts. Next, make sure the farming or fishing business in which you work meets IRS qualifying guidelines. In general, IRS guidelines for both occupations state you must be actively working in the industry and not simply buying or reselling crops, animals or the catch of someone else.

Gather Information

Information you need to complete Schedule J comes from IRS Form 1040. You need the Form 1040 you are currently working as well as the 1040 returns and any Schedule J forms you filed for the past three years. For the current year, fill out Form 1040 up to the point of entering the current year's taxable income to get the current year's taxable income, net capital gains you realized and the expenses and losses, if any, that you incurred during the year. After gathering the required information return to Schedule J.

Make Decisions

Decide how much of your current taxable income you want to elect as taxable for the current year. Although this can be any amount up to the total of your current taxable income, remember that the intent of income averaging is to “even out” your tax bill. Schedule J instructions state that depending on how the amount you decide on affects your tax bracket for the current and past three years, deciding on an amount less than your current taxable income may work to your advantage. Subtract the amount you decide on from your current taxable income to get the amount you will average over a three-year period.

Complete the Process

Use the previous years’ tax returns you gathered and the worksheets in the Schedule J instructions to assist you in finishing the form. Although income averaging can be of great benefit in reducing your tax liability for the current year, the process uses four separate tax tables to calculate your tax liability and be complex. Consider working with a tax professional to complete Schedule J.

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About the Author

Based in Green Bay, Wisc., Jackie Lohrey has been writing professionally since 2009. In addition to writing web content and training manuals for small business clients and nonprofit organizations, including ERA Realtors and the Bay Area Humane Society, Lohrey also works as a finance data analyst for a global business outsourcing company.

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