Tax Planning for a Large Windfall or Inheritance
When you receive a large sum of money, your life can change in many profound ways. However, a financial windfall is not without consequences. One of the most immediate of those consequences is your tax liability.
The largest sudden amount of money you may have come in to in your lifetime will likely also be associated with the largest tax bill you’ve ever seen.
You’ll need to plan ahead to budget for the taxes you owe and be diligent about key tax regulations you can use to your advantage to help reduce the amount of your newfound funds that you’ll have to give to the IRS.
Understanding How a Financial Windfall is Taxed
The specifics of how your newfound funds will affect your taxes are going to vary depending upon the source of the money.
In some situations, you will actually not owe federal tax even if you receive a large sum of money or other assets, but in other circumstances there will be tax implications. For example:
- If you receive an inheritance from a spouse: You will not be taxed on the inherited money or property regardless of the size of the inheritance.
- If you receive an inheritance from someone other than your husband or your wife: The estate may be subject to tax depending on the size of the inheritance.
- In 2020, up to $11.58 million in assets can be transferred upon death without any estate tax being assessed.
- Married couples can also transfer their estate tax exemption to their spouse. That means if a husband passes away first and leaves all assets to his wife or vice versa, the surviving spouse can now pass $23.16 million to heirs without the estate owing taxes as the widow(er) has or her own exemption plus the exemption of the deceased spouse.
- Some states will tax smaller estates, though, so it is possible that an estate will owe tax even when less valuable assets are being transferred. Estate taxes are paid by the estate, though. You will not owe them if you inherit, but your inheritance will be reduced by the estate paying them.
- If you receive an inheritance and you live in a state that charges an inheritance tax: You may have to pay these taxes to your local government. Only a small minority of states charge inheritance taxes and the amount due is usually based on how much you inherit and how close your relationship is with the deceased.
- If you receive a life insurance payout: You typically will not have to pay federal taxes on the money.
- If your windfall is from a lottery, other prize, or large bonus: You are typically taxed at your ordinary income tax rate. This means you will pay taxes on your windfall based upon your tax bracket as determined by your income and family size.
- If you receive a large lump sum from selling real estate or a business: You will likely be taxed at the long-term capital gains rate depending how long you owned the assets.
- If you profit off of selling shares in a company: More information on that here, if your company is acquired, or if you are selling the shares on the secondary market, or if your company IPOs.
Different states have different rules for how inheritances, life insurance payouts, lottery winnings or prizes, and the sale of a business or investment are taxed. You need to account for both federal and state rules when you determine your total tax liability.
When you have taxable income from a windfall, you should also be aware that the influx of funds that you have received may push you into a higher tax bracket.
Special Considerations for Certain Types of Inheritances: IRAs, Non-spouse, etc.
There are some circumstances where you’ll have special tax rules to follow as a result of receiving an inheritance or another windfall.
- If you inherit an Individual Retirement Arrangement (IRA), which is a tax-advantaged retirement account, you only have the option to transfer your account to your own IRA if the account was inherited from a spouse.
- If you inherit from anyone other than a spouse, you must follow specific requirements for taking required minimum distributions. This means withdrawing funds on a set schedule based either on your life expectancy or the time since the original IRA owner has passed away. You also have the option to take a distribution of all the money in the IRA in a lump sum but will be taxed on the entire distribution. In this case, the large amount of taxable income could cause you to move up to a higher tax bracket.
- If you inherit an asset that has appreciated in value since the deceased purchased it, a step-up in basis can also occur. When the asset is transferred to you, the step-up occurs and the new cost basis for the assets is the market value at the time of the inheritance. When you pay capital gains taxes in the future, the amount of the gains will be calculated after the step-up occurred.
Professional Tax Help for Inheritances and Windfalls
Above are just a few examples of things to know about the tax implications of a windfall. A tax advisor can assist you in tax planning so you are prepared to comply with your obligations to the IRS while limiting the taxes you have to pay.
They will have had experience managing clients who have had similar windfalls, family situations, general financial situations, and goals as you, and can flag certain parts of the tax law that you may not have thought to take advantage of, or help provide guidance on actions you’ll need to take as you go through the process of having the assets legally transferred to you.
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