Windfalls and your taxes

Elizabeth Rosen
by Elizabeth Rosen, Contributor

When you receive a windfall — whether it’s an inheritance from a relative, winnings from the lottery or gambling, or proceeds from a legal settlement — you may be anxious to start planning how you will spend that money.

But before you get too far ahead of yourself, you need to remember that you may owe federal taxes on the sum you received.

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As soon as you learn that a significant sum of money is coming your way, consider consulting with a qualified tax professional about the potential tax implications of your new wealth. In many cases, inheritances, gifts from family members or friends, and life insurance payouts are tax-free to the recipient. However, federal taxes may be owed by the giver or by the estate from which the inheritance is received. It is also important to take into account any state or local taxes, which may differ from the IRS rules regarding federal taxation.

Inheriting an IRA (Individual Retirement Arrangement)

If you inherit a traditional IRA from your spouse, there are usually three options you can choose from:

  1. You can treat the inherited IRA as your own by designating yourself as the account owner.
  2. You can treat the inherited IRA as your own by “rolling it over” into your IRA or (to the extent that it is taxable) into a.) Qualified employer plan, b.) Qualified employee annuity plan [Section 403(a) Plan], c.) Tax-sheltered annuity plan [Section 403(b) Plan], or d.) Deferred compensation plan of a state or local government [Section 457 Plan]
  3. Rather than treating the inherited IRA as your own, you can treat yourself as the beneficiary.

If you inherit an IRA from someone other than your deceased spouse, the IRS will not allow you to treat it as your own IRA. Therefore, you are not permitted to make contributions to the inherited IRA or “roll over” any amounts. Instead, you may consider setting up a trustee-to-trustee transfer so that you can be treated as a beneficiary of the inherited IRA, which means you won’t have to pay tax until you start receiving distributions. Or, you can opt to withdraw the money as a lump sum and pay all of the income taxes due in that year.

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Lottery or gambling winnings

Any winnings that you receive from playing the lottery or gambling are fully taxable and must be reported on your individual income tax return. It is important to remember that lottery and gambling winnings are considered taxable income (not capital gains) by the IRS.

The IRS has divided the types of gambling into four main categories:

  1. Horse Racing, Dog Racing, Jai Alai, and Other Similar Wagering Transactions
  2. Sweepstakes, Wagering Pools, and Lotteries
  3. Bingo, Keno, and Slot Machines
  4. Poker Tournaments

If you wish to claim gambling losses on your federal tax return, keep in mind that your losses must be reported separately as itemized deductions, not simply subtracted from your winnings. In claiming this tax deduction, remember that your gambling losses may not exceed your winnings. If your gambling or lottery winnings exceed specified amounts, you will receive Tax Form W-2G (Certain Gambling Winnings) from the IRS.

Use IRS Form W-2G (Certain Gambling Winnings) to report any gambling winnings, as well as any federal income tax that is withheld from those winnings.

NOTE: If you win a lottery prize that is payable in installments, on your tax return you are required to report both the annual payments and any amount designated as interest on the unpaid installments.

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You should file Form W-2G if any of the following situations apply to you:

  • Your winnings (not reduced by the wager) are $1,200 or more from a bingo game or slot machine,
  • Your winnings (reduced by the wager) are $1,500 or more from a keno game,
  • Your winnings (reduced by the wager or buy-in) are more than $5,000 from a poker tournament,
  • Your winnings (except winnings from bingo, slot machines, keno, and poker tournaments) reduced by the wager, at the option of the payer, are $600 or more and at least 300 times the amount of the wager, or
  • Your winnings are subject to Federal income tax withholding (either regular gambling withholding or backup withholding tax).

“Regular gambling withholding” refers to the withholding tax that applies to gambling winnings. You are required to withhold 25 percent of your gambling winnings for Federal income tax if your winnings (minus the wager) exceed $5,000 and are from lotteries, sweepstakes, wagering pools, or other wagering transactions (if your winnings are at least 300 times the amount you wagered). Additionally, in some cases your gambling winnings may also require state taxes to be withheld.

Legal Settlements

If you have won a lawsuit and have been awarded a monetary legal settlement, you are likely to owe Federal taxes on it. While certain settlements (such as damages for personal physical injuries or physical sickness) are considered non-taxable by the IRS, most other types of damages are taxed as ordinary income.

Types of damages that may be subject to Federal tax include the following:

  • Certain types of settlements for personal physical injuries or physical sickness
  • Proceeds received for emotional distress or mental anguish
  • Settlements from an employment-related lawsuit
  • Settlements for lost profits from your trade or business
  • Property settlements for loss in value of property (above a certain threshold)
  • Interest on any settlement (generally considered taxable as “ordinary income”)
  • All punitive damages (should be reported as “other income”)

Note that you may be required to make estimated tax payments if you are the recipient of a legal settlement. Additionally, in many cases, the percentage of the settlement that goes to your attorney will count as your taxable income. For more information, see IRS Publication 525 (Taxable and Nontaxable Income).

Conclusion

Suddenly receiving a windfall can be very exciting, but don’t forget to consider the Federal and state/local tax implications of coming into that much money. For specific advice regarding your unique circumstances, consider hiring a qualified tax professionals and/or financial planner.