Getting a windfall is a great way to stabilize your finances and lay a strong foundation for savings and retirement. But depending on the source, the United States government may want its share.
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.
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 by President Trump. If your regular income is less than $78,750, you do not need to pay any capital gains tax. If your income is between $78,750 and $434,550 ($488,850 for 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%.
- If you've received an unexpected windfall, it's wise to research the taxes you might owe to the IRS on that sum.
- If it's a sizeable amount, there are ways to help lower it.
- Some smart things to do with extra cash are to fund an IRA, health spending account, or another qualified retirement plan.
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 dollars you contribute to the IRA. For 2020, your 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. For 2019, the limits are the same as for 2020.
Income limits apply to IRA contributions, and you will pay income taxes on withdrawals in the future. Those withdrawals, however, will be made at a time 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. You keep your HSA funds for life, and so some savvy savers use the account as a supplemental retirement account. The IRS limits for HSAs for 2020 are going up by $50 for individual coverage and $100 for family coverage, bringing them to $3,550 and $7,100, 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 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 just 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 advantage of. While you already likely know about tax credits for parents, there are additional education-related deductions and credits 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 may be able to write those costs off as well. To take advantage of health-care tax deductions, your spending on health care must meet certain minimums and criteria that vary based on your income.
The Bottom Line
Taxes are something we cannot escape, but good planning and understanding can help you keep your tax bill as low as possible. Do your research ahead of time so that you don't need to scramble at the end of the year or in the weeks leading up to tax day.