How Sudden Windfalls Can Affect Your Taxes
For many Americans, every penny counts, and the idea of a sudden influx of cash -- an inheritance, gambling win or game show prize -- conjures images of new cars and sunny beaches. But, experts warn, don't take that luxury vacation before understanding the tax implications of your windfall.
It's Not Free Money
Any time you come into unexpected money, you'll receive a check (or cash) with one hand and a tax form with the other. That's right -- as soon as you're aware of your windfall, and possibly before, the Internal Revenue Service will know, too. How you'll have to declare it, and the rate of taxes on it, will depend on two key factors: the type of windfall, and the state where it occurs.
A gambling win in Las Vegas, for instance, is different from winning a charity bingo in Virginia. And laws governing inheritance tax vary by state. An inheritance tax in Iowa will be different from an estate tax in Rhode Island. Two states -- Maryland and New Jersey -- collect both an inheritance tax and an estate tax. If you live in California and your late Aunt Penny lived in North Carolina, you'll have to file a return in her state, as well as in yours.
Amy Wang, an accountant and technical manager at the American Institute of CPAs, tells people who come into sudden money to consult a tax professional before the first penny is spent. "It's dangerous," she said, "if you make poor decisions, you can end up actually owing more money at the end of the year than the money you actually received."
Minimize the Tax Burden
Jackie Perlman, principal tax research analyst at The Tax Institute, said one of the benefits of consulting a professional immediately following any windfall is that they'll be able to advise on how to keep as much of your gain as possible. "If you receive an unexpected bonus at work or win the lottery, you may be able to make additional contributions to your IRA, or make tax-exempt gifts to your children, or charitable donations that will lower the overall tax burden," she said.
For instance, rather than treating your family to an overdue vacation, utilize the IRS gift tax exclusion, which permits a tax-exempt gift of $14,000 per dependent in 2014 and 2015. You can still indulge them to that vacation by giving them the cash first, and having them buy their own ticket.
"There are many things that can help you lower your tax burden on a major windfall," Wang said. "You can make donations to your favorite tax-exempt political or charitable organizations, pay tuition or medical expenses for a loved one ... all things you might have done anyway."
Investing in a loved one is its own reward, but investing in your own future can also help ease your tax burden. "If you're working, make extra contributions to your IRA that will lower your overall tax burden. You might qualify for a deductible IRA, or you might have other deductions you can make, or make an extra payment of some kind," Perlman said. "But make sure you know what you're doing." Perlman also recommended ensuring you have enough withholding and estimated taxes to cover your liability so there are no surprises when you file in April.
The Downside of an Upside
There are worse things in life than being bumped up an income bracket, but Perlman warns that an influx of sudden cash can have far-reaching implications. "If you are somebody who has health insurance through the marketplace, and you got an advance premium tax credit," she says, "your windfall could have a dramatic effect on that tax credit."
It's not just health insurance that could be affected. College scholarships, low-income home loans or housing allowances could also be impacted. Like the myriad ways unexpected funds might arrive, there are myriad personal financial situations, and ways to manage them through windfalls and unexpected losses. And be aware that it might not be something an online tax software provider, or personal financial management app can walk you through.
Despite the immediate surge of an unexpected influx of cash, Wang advises looking at the bigger picture. "Always look at your long-term financial strategy, not just how to improve your current lifestyle," she said.