Dear Clients and Friends:
This month we would like to do something a little different in our Alert letter. It still pertains to taxes but in a more light-hearted way.
Have you ever thought about what you would do if you won a massive lottery, inherited a significant amount of money or maybe your company’s options finally paid off? Maybe you would purchase that sports car you always wanted, maybe a new home, take that big vacation you always wanted, help the kids with their student loans or maybe make a significant contribution to your favorite charity. Maybe all of the above.
We’ve all heard the sad stories of people who have won, acquired or inherited large amounts of money, only to be broke in a few years. There are many reasons this might happen, but there is one thing that isn’t always considered and that is the tax bill that comes along with the windfall.
Not all windfalls will be taxed the same because one may be taxed as ordinary income, another may be capital gain and another may actually be tax-free. Not all of the taxes we discuss will apply to every windfall but we intend to show you what can happen with taxes.
Federal Income Tax
Let’s say you win the lottery, have a large short-term gain or receive a large bonus. These will typically be taxed at ordinary rates. The maximum tax rate is 39.6%. This tax rate applies to a single taxpayer with a taxable income over $413,200, joint filers $464,850 and $439,000 for taxpayers filing head of household for 2015. Here can be one surprise. Lottery winnings typically have federal withholding of 25% withheld at time of winning. When you file your tax return and find out that you still owe 14.6% (39.6% - 25.0%) to the IRS. This can be a real surprise.
You also pay state income tax on your winnings unless you live in a state with no income tax. This can be another surprise. Minnesota’s maximum tax rate is 9.85%. There may be some planning opportunities available based upon the timing of the payment of any state tax liability.
Medicare Tax on Windfalls treated as Wages
If your windfall comes in the form of a large bonus, cashing in non-qualified stock options or a severance payment, these will most likely be considered taxable wages. The typical payroll taxes of Social Security and Medicare will apply. Social Security income has a maximum taxable amount of $118,500 for 2015. However, Medicare wages has no limit. The Medicare rate is 1.45%. However, once an employee meets a $200,000 threshold, any additional wages require Medicare withholding at a 2.35% rate forever. An additional .9% doesn’t sound like much but it is an additional tax.
3.8% Net Investment Income Tax
Windfalls such as large stock gains or a sale of company are considered investment income. The net investment income tax kicks in when modified AGI reaches $200,000 for single and head of household filer and $250,000 for joint filers. The amount subject to the additional 3.8% tax is the lesser of 1) net investment income or 2) the amount by which modified AGI exceeds the applicable thresholds.
Federal and State Estate Taxes
Federal and state estate taxes are the responsibility of the descendant and not the taxpayer’s heirs. However, in reality the heirs will ultimately receive less inheritance because the estate taxes need to be paid first. The federal estate tax has a fairly generous limit of $5.43 million before the estate tax needs to be paid. But after the limit is reached, the rate hits at 40%.
Depending in which state the decedent lives, there may be state estate tax to pay. Usually the exemption amount is not nearly as generous as the federal amount. Minnesota has an estate tax and the exemption is $1,400,000 with rates between 9-16%.
Additional Tax Benefits Can be Lost
Windfalls treated as taxable income can trigger the loss of many tax benefits due to the many phase-out rules in place. For example, education benefits such as the American Opportunity Credit, Lifetime Learning Credit and the deduction for college education can be lost. Personal and dependent exemptions deductions are lost. The additional income may cause the loss of itemized deductions up to 80%. These are not huge items but have the effect of actually increasing the income rates discussed above.
To demonstrate the effect taxes can have on a windfall, let’s take a very simple example. Let’s say an individual, after the cash option nets $130 million in the lottery. Not bad. He doesn’t do anything fancy. Pays the income tax and breaks even until his death, dying with an estate of $62 million. ($130 less $51.5 in federal tax and $16.5 million in state income tax) If the taxpayer dies in 2015, his estate tax after the $5.43 million exemption is $22.6 million. ($62 million less $5.43 million times 40%) The taxpayers’ heirs would get $39.4 million. $90.4 million lost to taxes. Roughly 70% of the original amount of $130 million lost to taxes. It gets even worst if the decedent lived in a state with estate taxes.
What to Do?
As you can see, the tax consequences of a large windfall can be severe. Planning is extremely important any time you have a big change in your financial life. Proper planning will not eliminate the tax consequences, but it will help mitigate them and help you reach your desired goals. Call us and we will be happy to help you the next time you have a financial windfall.
SCHLENNER WENNER & CO
St Cloud, MN