Riddle: When could a bonus or windfall ever cast a cloud on your good fortune?

Answer: April 15th.

Yes, it’s inevitable: That bonus for a job well done or inheritance from Great Uncle Alfred can often result in your paying a bigger chunk of money to the Internal Revenue Service. And not just an ordinary amount of extra money: Given the many wrinkles in the U.S. tax code, even a smallish wad of cash – modest lottery winnings, say – can have outsized repercussions. Start with the simplest scenario with a downside: A bump up might lift this year's income into a higher tax bracket. Worse still, if you earn a high income and live in a state with a lofty tax rate – New York, California or New Jersey, to name three – the extra boost might push you past the Alternative Minimum Tax (AMT) threshold and effectively sap your ability to take a number of itemized deductions, including those on state and local taxes.

Heed another precaution, says Rosalind Sutch, a Philadelphia CPA at the tax consulting firm Drucker & Scaccetti: If you work in two or more states during the year, you might have to pay taxes on your bonus to each state.

Take heart: Your tax adviser can map out a few strategies to let you keep as much of that extra cash as the IRS allows. Here are a few worth mulling over:

1. Set it aside for later.

Remember, Uncle Sam truly wants you to have a great retirement. He’s encouraging us all to build up our nest eggs by using contributions to qualified retirement savings accounts such as 401(k)s and traditional IRAs to reduce taxable income. With that in mind, a bonus or windfall can represent a great way to jumpstart your retirement savings, especially if you’re allowed to use your bonus to make a special contribution. That, of course, will depend on your plan's rules.

401(k)s - It might make very good sense to use the extra cash to maximize your 401(k) contribution. The move may even reap an additional reward if your employer kicks in a matching sum – provided you qualify under plan guidelines. Under IRS rules, your maximum contribution this year is $17,500, although it’s possible to chip in another $5,500 if you are over age 50.

IRAs - In 2014, the IRS allows you to contribute up to $5,500 to an IRA and an additional $1,000 if you’re over 50. The deduction you can take on IRA contributions, however, is subject to limits based on your income, filing status and whether your employer has a retirement plan in place.

Conversion - Another strategy, says Sutch, is to make a contribution to a non-deductible IRA, then convert the account to a Roth IRA as quickly as possible – at very least before the end of the year. You will have to pay taxes on any gain made on any increase in value of the converted IRA, but distributions you take later will be tax-free. That’s an important consideration that can save you money if the assets of the Roth IRA increase, tax rates are lifted or you end up in a higher bracket on the eve of your retirement. The caveat is that you’ll need to walk through the paperwork carefully with your accountant to avoid tripping up and generating taxable income, especially if you already have an IRA. And you need to fit the Roth income limitations.

2. Hold it off.

When it comes to bonuses, the IRS expects you to ante up a flat 28% of the money you receive to federal income tax withholding.

From that starting point, you have a number of options. For one, you might look into a deferred compensation plan at work, which will allow you to spread out both the money you pocket and the tax liability. If you are paid in shares or stock, you’ll want to mull over the best time to cash out of a security that has logged a gain – in order to offset or limit capital gains.

3. Pay your taxes.

Yes, the heading here sounds like a no-brainer. But let’s be a bit more specific: One beneficial way to use your bonus is to “catch up” on estimated tax payments or your withholding-tax obligations and thereby sidestep an IRS penalty for coming up short.

And that’s not all you can do. If your windfall puts you in danger of paying the AMT this year, you might be able to pay next year’s real-estate taxes in advance. The IRS will let you deduct payments for a year out but no more, so check with your accountant before you try this tack.

4. Give it away.

There’s a way to get the lift of contributing a hefty sum to charity over time and yet reap an immediate tax deduction for the current year. Sutch says you can set up a donor advised fund (DAF). Under IRS guidelines, you can use your bonus or windfall to fund an account and set up regular distributions to the charity of your choice. The upside: You get to essentially front load the charitable deductions you make over a number of years. Bear in mind: The IRS sets no minimum amount that you have to give to the recipient charity each year, although the investment firm that houses the DAF may set a floor on annual distributions.

5. Pay up your expenses.

Another way to shelter a bonus or windfall is to pay upcoming deductible business or personal expenses before Dec. 31. You might consider upgrading computer equipment or footing utility bills for your home office before year’s end. Using a credit card may make sense, provided you can pay off the additional balance in January.

Another idea: If you’re signed on for a health savings account at work, consider using part of your bonus or windfall to pay up to the contribution limit. Just be sure it’s money you can carry over to next year, or that you know you will spend in time.

The Bottom Line

As soon as you catch wind of a bonus or windfall, book a meeting with your tax adviser to start safeguarding as much as you can.

“Like a lot of tax issues, things can get very complicated,” says Sutch. “You don’t want to get whipsawed on some of the more intricate rules, so it’s a good time to lean on a competent tax adviser’s advice.”

The only windfall that won’t put you in that situation: the up to $14,000 someone can give you tax free each year. Neither you nor the giver owes taxes on a gift that falls within the legal limit. Such gifts can add up: For example, if all four of your grandparents gave you the maximum, you could collect $56,000 per year, gift-tax free.

Related Articles
  1. Budgeting

    How To Handle A Windfall

    It can be tempting to spend a windfall on toys, trips, and other things that you "deserve," but doing so will leave you in the same place you were before you received the windfall. Find out what ...
  2. Taxes

    What Are Gift Taxes?

    If you're not sure what gift taxes are, read on and we'll explain.
  3. Credit & Loans

    What Should You Do With Your Christmas Bonus?

    The economy is picking up and companies are paying bonuses again. Should you spend it or save it?
  4. Taxes

    Pay Taxes Like A Billionaire

    The richest people know the ropes when it comes to paying as little in taxes as possible. Find out how you can do the same.
  5. Taxes

    How to Tell if You Need an Estate Planning Lawyer

    Estate planning is an important and often neglected part of financial planning, which can be costly when avoided or done improperly.
  6. Professionals

    Holding Out for Capital Gains Could Be a Mistake

    Holding stocks for the sole purpose of avoiding short-term capital gains taxes may be a mistake, especially if all the signs say get out.
  7. Professionals

    Advisors: Warn Clients About These Audit Triggers

    There are several factors that may increase the risk of an audit, especially with high-net-worth clients.
  8. Professionals

    3 States Where Taxes Can Hammer Retirees

    Knowing which states ding retirees with the highest tax implications should be part of your retirement research.
  9. Savings

    All About Income

    Income is the money you or a business earns by providing goods or services, or through investments.
  10. Professionals

    Best Ways to Avoid RMD Tax Hits on IRAs

    If you want to avoid hefty tax penalties, read this cheat sheet on IRA required minimum distributions.
RELATED TERMS
  1. Non-Qualified Deferred Compensation ...

    Compensation that has been earned by an employee, but not yet ...
  2. Deferred Compensation

    An amount of earned income that is payable at a later date. Most ...
  3. Wealth Management

    A high-level professional service that combines financial/investment ...
  4. Tax Deductible Interest

    A borrowing expense that a taxpayer can claim on a federal or ...
  5. Debt-To-Income Ratio - DTI

    A personal finance measure that compares an individual's debt ...
  6. Proof of Charitable Contributions

    Substantiation required by the Internal Revenue Service for a ...
RELATED FAQS
  1. Are my Social Security disability benefits taxable?

    Social Security disability benefits may be taxable if you receive other income that places you above a certain threshold. ... Read Full Answer >>
  2. What are the best free online calculators for calculating my taxable income?

    Free online calculators for determining your taxable income are located at Bankrate.com, TaxACT.com and Moneychimp.com. Determining ... Read Full Answer >>
  3. In what instances does overhead qualify for certain tax allowances?

    Businesses are just as keen as anyone else to keep their tax burdens low by any means possible. Overhead expenses often qualify ... Read Full Answer >>
  4. Is there a situation in which wash trading is legal?

    Wash trading, the intentional practice of manipulating a stock's activity level to deceive other investors, is not a legal ... Read Full Answer >>
  5. How are write-offs recorded on my tax return?

    The way your write-offs are recorded on your tax return varies depending on whether you are filing a personal or business ... Read Full Answer >>
  6. How is the deductible I paid for my insurance claim treated for tax purposes?

    The deductible you pay on your health insurance policy may be tax-deductible if you meet certain conditions. However, whether ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!