From SmartAsset.com —
By Sarah Sharkey —
A windfall of a large sum of cash is something to celebrate. But if you don’t play your cards right, the government will expect a major part in taxes. The good news is that smart tax planning strategies can help you minimize your tax burden. Let’s explore how to avoid taxes on a large sum of money. The ideas below are a great way to get your wheels turning. But consider speaking to a financial advisor for customized advice about your unique situation.
Sources of large sums of money
You can come into a single large sum of money in several ways.
An inheritance: If you receive an inheritance from your spouse, you won’t have to pay federal taxes on that windfall. If you receive an inheritance from another family member, the size of it impacts whether or not you have to pay federal taxes. You’ll only have to pay federal estate tax if the inheritance is for more than $12.06 million as an individual in 2022.
A life insurance payout: Many lump-sum death benefits are not subject to income taxes because the policyholder makes premium payments along the way.
A gift: You can receive up to $16,000 as a gift without federal tax obligations.
An asset sale: The money you receive from selling an asset may be subject to long-term or short-term capital gains taxes. Capital gains are calculated by subtracting the cost of the asset from the sale price. If you’ve owned the asset for less than a year, the IRS will tax the gain as ordinary income.
A lottery win: Lottery winnings are taxed as ordinary income. With that, the size of your winning determines what percentage you’ll pay in taxes.
The type of windfall impacts your tax obligations. But it’s possible to minimize your tax liabilities with savvy strategies. Let’s explore some of your options below.
Tax-advantaged accounts
Tax-advantaged accounts offer a great opportunity to lower your burden. The strategy works by lowering your taxable income by the amount you tuck away into one of these accounts. Here are two of the options:
Individual Retirement Account (IRA): You can contribute up to $6,000 per year into an IRA, or $7,000 if you are at least 50 years old. Although you’ll have to pay taxes when you withdraw the funds, this can limit your current tax hit.
Health Savings Account (HSA): If you have a high-deductible health plan, an HSA offers three tax advantages. You won’t have to pay taxes on contributions, investment growth or withdrawals for qualified medical expenses. You can contribute up to $3,650 to an individual HSA or $7,300 to a family HSA in 2022.
Tax-loss harvesting
Tax-loss harvesting allows you to lock in investment losses for the express purpose of lowering your taxable income. For example, let’s say you have a stock portfolio with some bad performers. When you have a windfall, it’s a good time to offload those bad apples.
The catch is that capital losses are only used to offset capital gains. So, this strategy will only work if your windfall stems from the profits of a great investment.
Deductions and credits
While tax deductions will lower your taxable income for the year, tax credits reduce the amount of taxes you owe. Both result in lowering your tax costs.
One popular tax credit is the Child Tax Credit, which is worth up to $2,000 per dependent child. Another is the Federal Adoption Credit, which is worth up to $14,890 for families that adopt eligible children.
In terms of deductions, most opt to take the standard deductible, which reduces taxable income by $12,950 for single filers and by $25,900 for married joint filers. But you may choose to itemize your deductions if you have significant charitable donations or write-off expenses.
Depending on your situation, you may qualify for a variety of tax deductions or credits. When you have a windfall on your hands, it’s especially important to consider all possible deductions and credits.
Although most choose to go with the standard deduction, itemizing could lead to more tax savings in some situations.
Large donations to charity
Donating to charity is a win-win! You’ll lower your tax burden, and the charity gets a sizeable donation to make great things happen. You can deduct qualified charitable donations within limits. The IRS won’t allow you to deduct more than 50% of your adjusted gross income.
Sometimes, setting up a charitable trust may be more tax efficient than a standard donation. Work with a financial advisor to sort out the best charitable tax strategy. Before opting for the charitable route, do some research to make sure the charity is legitimate.
Open a charitable lead annuity trust
A charitable lead trust is a form of irrevocable trust. This means that once you establish the trust and make contributions to it, you cannot take those assets back.
With a charitable lead trust you establish a set term for charitable giving. This can be defined by either an amount of time or a condition. The trust then makes charitable donations during this period. For example, the trust might make charitable donations for five years or until some named individual dies. This period is known as the “term of the trust.”
Once the term of the trust ends a charitable lead trust gives the remainder of its assets to named beneficiaries. Beneficiaries can be you, friends and family, or anyone else you choose. The same as how you choose charities, when you establish a charitable lead trust you choose its beneficiaries and how they will receive the trust’s assets.
When you create a charitable lead trust you can define how it distributes its assets. This means that you name the charities that the trust gives to, as well as how large the donations are. You can do this through a wide variety of mechanisms, such as nominating a percent of assets or a defined amount of money that a charity will receive.
Use a separately managed account
A separately managed account (SMA) is a portfolio of securities you can invest in. SMAs can help reduce taxes owed on capital gains. In other words, this means how much an investor owes in taxes if the sale price of a security is higher than the purchase price.
An SMA is similar to an ETF or mutual fund. However, when you invest in a SMA, you own all the securities within your portfolio. This gives you a bit more flexibility as to how those funds are invested and managed, as well as the transparency to monitor trades in real-time.
SMAs are managed by professional money managers. Fees may be higher than those associated with mutual funds, but it may be the case of you get what you pay for. For example, you may have more involved management and flexibility when it comes to your investments.
Bottom line
Everyone wants to hang onto as much of their windfall as possible. Although you’ll likely have to hand over some of your cash to the IRS, implementing smart strategies limits the pain of giving up some cash. Speak with a tax professional to make sure you take advantage of all the tax minimizing strategies at your disposal.
Contact the Pinnacle CPA Advisory Group
Contact the experts at Pinnacle CPA Advisory Group if you need help with any individual or business tax or accounting issue. Call us at (614) 942-1990, reach us with email sent to [email protected], or just fill out the Contact form on this site at cpaagi.com/contact