Getting a windfall is a great way to stabilize your finances and lay a strong foundation for savings and retirement whether you win the lottery, cash in at the casino, receive an inheritance from your great-aunt, or just found some money you never realized you socked away. But depending on the source, the United States government may want its share. This means you may have to report your new fortune on your annual tax return. Below, you'll find some tips to help you lower your tax bill while you pay your fair share.
- Research the taxes you might owe to the IRS on any sum you receive as a windfall.
- You can lower a sizeable amount of your taxable income in a number of different ways.
- Fund an IRA or an HSA to help lower your annual tax bill.
- Consider selling your stocks at a loss to lower your tax liability.
- Be sure to take advantage of the forgotten credits and deductions, such as those related to education and health care.
1. Understand Tax Implications
Before you start to worry, research the tax rules for your specific income source. If the income comes from something like a lottery or employer, you'll need to pay full taxes at your tax bracket on the income. Other sources have different rules. For instance:
- If your income comes from investment gains, you will need to pay capital gains tax, which changed with the Tax Cuts and Jobs Act (TCJA), signed into law on Dec. 22, 2017.
- If your regular income is less than or equal to $40,400 (for single) or $80,800 (if you're married filing jointly) you do not need to pay any capital gains tax. If your income is greater than $40,400 (for single) or $80,800 (for married filing jointly) but less than or equal to $445,850 (for single) or $501,600 (if you're married filing jointly), you pay 15%.
- If your income exceeds the 15% threshold, your capital gains tax rate is 20%. There are also exceptions where certain capital gains might be taxed at higher than 20%.
2. Fund an IRA
The first place to look to lower your taxes is in your retirement accounts. Contributions to a traditional individual retirement account (IRA) or a 401(k) plan are tax-deductible. That means you don't pay any taxes on the money you contribute to the IRA.
For 2021 and 2022, the total contributions to all of your traditional and Roth IRAs cannot be more than $6,000 ($7,000 if you're age 50 or older), or your taxable compensation for the year, if your compensation was less than this dollar limit.
Income limits apply to IRA contributions, and you will pay income taxes on withdrawals in the future. However, those withdrawals will be made when you'll likely have a lower income, so your total taxes paid will be lower.
3. Fund an HSA
If you have a high-deductible health plan (HDHP), you'll probably qualify for a health savings account (HSA). With an HSA, the funds may be used only for qualified medical expenses such as doctor appointments, hospital visits, prescription medications, and doctor-ordered lab tests.
With an HSA, your contributions are tax-deductible, and you pay no taxes on withdrawals. This means that you keep the funds in your HSA for life, so savvy savers use the account as a supplemental retirement account.
The IRS limits for HSAs for 2022 are going up by $50 for individual coverage and $100 for family coverage, bringing them to $3,650 and $7,300, respectively. The catch-up contribution limit for those older than age 55 will remain at $1,000.
4. Sell Sluggish Stocks
If you have underperforming stocks in your portfolio, you can sell stocks at a loss to lower your capital gains for the year. Capital losses can offset capital gains but cannot be used to lower your taxes beyond that amount. Any additional capital loss is carried over to the next year.
Always think carefully before selling a stock. It is better to pay capital-gains taxes and make money than it is to lose money. Don't sell to avoid taxes. But if you were going to sell anyway, you can try to time your sale in a tax year that will be most beneficial.
5. Research Additional Deductions and Credits
There are dozens of tax deductions and tax credits available that many Americans don't take. While you already likely know about tax credits for parents, additional education-related deductions and credits are available. Those are available for both children and classes at an accredited college or university that you are taking yourself.
If you incurred steep health care expenses in a single calendar year, you might be able to write those costs off as well. To take advantage of health care tax deductions, your spending on healthcare must meet certain minimums and criteria that vary based on your income.
The Bottom Line
We cannot escape paying taxes, but good planning and understanding can help you keep your tax bill as low as possible. Do your research ahead of time so you won't need to scramble at the end of the year or in the weeks leading up to tax day.