How to Calculate Taxes on a Cash Windfall

How to Calculate Taxes on a Cash Windfall
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If you have received a cash windfall, the chances are good that you have access to significantly more financial resources than you had before. Unfortunately, it is a virtual certainty that you will also have to pay taxes on that amount. Exactly how much you pay depends on how you received the money and who gave it to you.

If you have obtained your cash windfall through gambling or form of contest, you will have to pay tax on the funds corresponding to the standard income rates. However, if you received the money as part of a gift from a family member or close friend, there is a good chance that you will not have to pay tax on these funds at all. Inheritances may still be subject to taxation.

Calculating the Windfall Tax Rate

If you’ve won the lottery or had a big win at the racetrack or casino, you’ll owe tax at your ordinary income rate for that amount. The downside is that a big win can put you into another tax bracket.

Figure out what you’ll owe the IRS by calculating your income for the year, based on earned and unearned income. Add your winnings to the amount of earnings to see if the tax bracket moved upward. Keep in mind that your state will probably want a piece of your winnings for tax purposes, too. Contact your state’s department of revenue or that of the state in which you won the money for more information.

If your windfall results from a legal settlement or court judgment, you’re likely to owe taxes on it. The exception is for damages for personal injury or illness, including emotional stress or mental anguish. Any type of punitive damage award is considered taxable and is reported as other income on ​Line 7a​ (changed to ​Line 8​ on the draft 2020 version) of Form 1040. There are many variations in legal settlements and judgments, as well as exceptions, so it is crucial to receive professional tax advice, especially if the court judgment is substantial.

Exceptions for Parental Gifts

You don’t have to pay taxes on parental cash gifts as long as the parent claims you as a dependent on their tax return. Once you are no longer a dependent, your parents must pay taxes on gifts over a certain amount, as stipulated by the IRS. If the gift goes toward paying educational or medical expenses, there is no limit.

However, the person making the gift must pay it directly to the educational institution or medical facility, rather than giving the money to the student or patient and having them pay the tuition or medical bill. If you’re married, there is no limit to the amount of cash or other gifts spouses can give each other.

State Taxation Rules

Whether you must pay tax on an inheritance depends on who left you the money, the amount inherited, the type of asset and the state. Not many states impose an estate tax, and some that do like Oregon and Washington use the federal exemption as a basis. Just a few states impose an inheritance tax (Nebraska, Iowa, Kentucky, Pennsylvania), and the exemption is often much lower.

The exemptions are usually very low for those who are not lineal descendants of the deceased. That’s anyone who isn’t a child, grandchild or great-grandchild. Contact the department of revenue in the state in which the deceased person lived to find out if they impose an inheritance tax.

There is no bonus tax rate for this – if you owe, you'll merely owe a percentage of the windfall to the state. If they do, you can calculate how much tax you will owe, if any, by your relationship to the deceased and the amount left to you.

2020 Tax Changes and Gift Taxes

The Tax Cuts and Jobs Act ups the amount parents can give before Uncle Sam gets involved. For ​2020​, each parent can give you up to ​$15,000​ per year tax-free. Over a lifetime, a person's estate can give up to ​$11.18​ ​million​ tax-free.