How to Withhold Federal Taxes on a Lump Sum Payment

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Getting a lump-sum payment can be a tremendous blessing for many taxpayers. However, taxes must be taken into account here as with all other forms of income. In some cases, the tax should be withheld at the time of payment, while other times it may make more sense to wait until you file your return to pay Uncle Sam.

Assess the value of your lump sum. If it is a small amount, such as less than $5,000, then the impact to your taxes will most likely be minimal. If it is a large amount, such as $50,000, then the impact will obviously be larger. If you get a refund each year and your lump sum is small, then you might be wise to simply take the entire amount and let the tax owed come out of your refund.

Examine your tax return from last year and see how you owed or were refunded. Look at your tax bracket and your effective tax rate (the ratio of actual tax you paid after all deductions and credits versus your income), which might be lower due to tax credits received. These numbers will provide a starting place from which to make an estimate of the appropriate amount of withholding for your lump sum.

Prepare a hypothetical return incorporating your lump sum in with all of your other income and deductions. You can simply add this amount to last year's numbers if your income and deductions for this year look to be about the same, or you can adjust these numbers if necessary.

Compare the effective tax rate of both returns to see how much tax may need to be withheld. If you got a huge refund last year, then you may not need to have as much tax withheld as you would if you owed money. But the effective rate of tax will be about equal to the percentage of tax that you will probably have to pay on your lump sum.

Specify the amount you want to have withheld from your lump sum, if that is possible. If not, then you have the option of either sending in an estimated tax payment equal to the amount or setting that amount aside for the following year.

Repeat these steps for state and local income taxes.