Tax Tips for People Who Come Into Unexpected Money
By Tim Frye
Sometimes there are occasions in life when God shines his light down on you and showers you with riches. Or just a fat legal settlement. Or a huge lottery ticket. Or a gambling windfall. Before the recipient of this money goes manic, it may be wise to think about the fact that there will still be federal and state income due on that money in the majority of cases. So don’t go spending all that money in one place. Uncle Sam awaits. And he wants his cut. Here are some tax tips for dealing with income tax when you come into unexpected money.
Are You Falling Into a Higher Marginal Tax Bracket?
When that lucky someone wins the lottery and cashes a hundred thousand, how is that money taxed? Usually, depending on the source, the recipient will get a W2-G Form reporting their winnings and they have the choice to take out some federal and state income tax when they get paid out. The IRS splits gambling winnings into different categories, but they are all taxed at regular tax rates, not the cheaper capital gain rates. Many people think ahead and pay taxes on that money and think everything will be all good from there. This is not the case.
Let’s say you are filing single, no dependents, and already make one hundred thousand a year. This extra hundred thousand must be reported in its entirety in the year that it is earned, as earned income. So your effective and marginal tax rates are going to sky rocket if you have limited deductions. You could end up in a marginal tax bracket as high as 28% on the federal and beyond ten on the state if you live in California. So you may want to put an immediate 25% of that money away immediately and consider it gone, because if you don’t, that midyear joviality can transform into a New Year monstrosity by year’s end.
What Happens When I Am Awarded Damages or Win a Lawsuit?
There are workers out there that are awarded damages from their previous employers. There are taxpayers out there who were awarded large settlements after winning a civil judgment. The first tip when it comes to settlement payouts is to determine if they are taxable. Elementary, my dear Watson, elementary. We know, though this seems obvious to most, many people automatically assume that lawsuit settlements are not taxable and they don’t bother to report them on their 1040 at tax time. They never stopped to think whether Uncle Sam felt like taking a chunk out of that lump sum. In fact, most legal settlements are taxable. The exclusions are really only for damages for personal physical injuries or dire physical infirmities, and those are not subject to taxation by the IRS or nor are these payments hit by any state tax. Most other damages are classified as ordinary income and taxed accordingly. Here are some examples of federally taxable damage payouts:
-Certain settlements for physical infirmities or physical injuries
-Any Funds distributed due to emotional distress or mental hardship
-Payments made due to loss of profit from taxpayer trade or business
-Interest and all punitive damages on any settlement
The IRS may also require the recipient of these types of taxable settlements to make quarterly estimated payments or the individual may be subject to the estimated tax penalty at year’s end. Oh, and don’t forget, even the portion of the money that goes to pay for your lawyer is considered taxable income to you come tax time. See IRS Publication 525 for further detail on this matter.
Hire a Tax Professional
This is one of those cases where the one thing you should do with all that new found money is hire the best tax professional money can buy. In the end, it will pay off in a less complex situation and possibly significantly lower tax bill. There are so many stipulations and provisions regarding these types of payouts, so many it is hard for even the best tax guy to keep up with. So if you go it alone, you may miss out on certain tax loopholes you could have accessed had you known about them. Winning a large settlement or winning the lotto can be an exhilarating experience, but don’t think just because those numbers matched up on your ticket the numbers will match up on your tax return.
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