Windfalls and Your Taxes

When you receive a windfall—whether it’s an inheritance from a relative, lottery or gambling winnings, or a legal settlement—you may be anxious to plan how you will spend that money. However, don’t forget that taxes may be owed on the sum you received.

As soon as you learn that a significant sum of money is coming your way, consult with one of our qualified tax professionals about potential tax implications. In many cases, gifts from family members or friends, life insurance payouts, and inheritances are tax free to the recipient, although taxes may be owed by the giver or the estate from which the inheritance is received. It is also important to consider state and local taxes, which may differ from Federal rules.

Inherited Retirement Accounts

If you have inherited a traditional IRA from someone other than your spouse, you can opt to withdraw the money as a lump sum and pay all of the income taxes due in that year. Or, you can delay the tax liability by directly rolling the funds over into an inherited IRA. You will have to take required minimum distributions (RMDs) from the account and pay taxes on these withdrawals; however, you can extend RMDs based on your anticipated life expectancy. You may also choose to transfer the IRA to another beneficiary within nine months of the account owner’s death. Due to a recent change in the law, most non-spouse beneficiaries of 401(k) and other employer-provided retirement accounts are also permitted to roll over funds into an inherited IRA.

Lottery or Gambling Winnings

Any winnings from gambling or playing the lottery are fully taxable as ordinary income, not as capital gains. If you win a lottery prize payable in installments, you are required to report on your tax return both the annual payments and any amount designated as interest on the unpaid installments. If your lottery winnings exceed $5,000, the payer will automatically withhold 25% of your winnings to cover Federal taxes—this percentage may be greater if you fail to disclose your tax identification number. In some cases, state taxes will also be withheld. In addition, you may owe estimated taxes, which must be paid quarterly. Failure to pay estimated taxes in a timely manner can result in penalties.

All gambling winnings are considered income on your Federal tax return, and the proceeds may also be subject to state taxes. If you wish to claim gambling losses on your Federal return, they must be reported separately as itemized deductions, not simply subtracted from the reported winnings. In claiming this deduction, your gambling losses may not exceed your winnings. If your gambling or lottery winnings exceed specified amounts, you will receive form W-2G, Certain Gambling Winnings, from the IRS.

Legal Settlements

If you have won a lawsuit and have been awarded a legal settlement, you are likely to owe taxes, unless the damages were awarded for physical injury or illness. Most other types of damages, including settlements for personal non-physical injuries and all punitive damages, are taxed as ordinary income. To complicate matters, the percentage of the settlement that goes to your attorney in many cases also counts as your taxable income. While you are permitted to claim legal fees as an itemized deduction, this deduction could increase your alternative minimum tax (AMT) liability.

Sharing Your Windfall

If the lump sum you have received is liable to taxation, you may be able to reduce taxes by donating some of your windfall to a qualified charity. Keep in mind, however, that the deductibility of charitable gifts is limited to 50% of your adjusted gross income (AGI), although contributions that exceed these limits may be carried over for up to five years into the future. Gifts to family and friends from your windfall will not reduce your tax liability. In fact, there may be additional gift taxes involved.

Suddenly receiving a windfall can be very exciting, but don’t forget to consider your tax liabilities. For advice according to your unique circumstances, consult your qualified tax professionals.

 

 

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