Don’t let your windfall become a tax nightmare!

Everyone loves a windfall! That is, until they see the tax bill. There are a number of circumstances that can result in a large amount of unexpected income in a single year, which may be great for your savings, but could have unforeseen consequences when it comes to your tax return. For anyone who has received a large taxable gift, been obliged to liquidate non-qualified plan savings (as in the case of a 457 plan being dissolved), won a large settlement from a lawsuit, received life insurance proceeds, won the lottery, or received other large amounts of taxable income, careful planning can help mitigate the impact on your income taxes.

There’s an old joke that says: “How do you cut your income taxes in half? Easy—cut your income in half!” At Coldstream we like to take a more nuanced approach—we don’t suggest cutting income, of course, but rather focus on reducing taxable income in the year a windfall is received.

A windfall year will most certainly be a high tax year, possibly even bumping you into a higher tax bracket, so this is likely a year to take advantage of and boost as many deductions as possible. For example:

• Don’t use your windfall to pay off your mortgage! You’ll want to make full use of the mortgage interest deduction.
• If you have been thinking of purchasing a residence, this year might be a good time to do it by taking out a new mortgage and reaping the interest deduction. (Yes, you may want to take out a mortgage even if you pay it off in the tax year following the windfall)
• Taking out a mortgage to buy a vacation home—for personal use or for rental—is another way to generate deductions from taxable income. If the property is rented out less than 14 days per year, you may be able to deduct the interest on your personal return. If rented for more than 14 days, mortgage interest may be allocated between personal and rental use and interest may be deductible on Schedules A and/or E.
• Keep your capital gains to a minimum by putting off the sale of your current home or investments until the tax year following your windfall.
• If you are charitably minded, using some of your windfall for philanthropy can provide deductible expenses. You could give to a donor-advised fund (DAF) or set up a charitable foundation to take a large tax deduction up front while disbursing the funds over time. Charitable remainder trusts can also be a great way to generate a large deduction in the year of the windfall and generate a cash flow for your family that is customized per the trust terms.

There are some actions you should incorporate into your financial strategy in the year of an income windfall:

• Make sure you are contributing the maximums if you have a 401(k) plan and/or Individual Retirement Account (IRA). This will reduce your taxable income.
• If your spouse has access to tax-deferred accounts such as a 401(k) or IRA, make sure they are contributing the maximum as well.
• Avoid contributing to any Roth accounts this year, as those contributions will be taxed at your higher rate. This includes company 401(k) plans for you and your spouse; in a windfall year, it is best to contact HR and make sure those payroll contributions are going to your plan as after-tax dollars, rather than being coded as Roth contributions.
• If you and/or your spouse has a Health Savings Account (HSA), make sure you are contributing the maximum.
• Consider investing in municipal bonds and/or US treasuries, as the income from these bonds may not count toward taxable income.
• Consider investing in a direct index—automated stock trading strategies that capture tax losses may be helpful in the year of a windfall if you have other assets that are generating capital gains. Capital gains rates are tied to income, so we do everything we can to minimize or eliminate capital gains in the year a windfall is received.

How you manage your windfall—both the tax planning and what you do with your new assets—will depend on your situation, your objectives, and your plans for the future. Identifying and employing appropriate tax strategies, choosing how to save and invest your assets, and figuring out how much you can safely spend can become complex and layered tasks.

At Coldstream, we can help you examine the risks and opportunities, pinpoint important considerations, and make informed decisions to help protect your estate and your future. We’ll work with you to understand your situation and goals and build a plan to meet your needs. Please feel free to reach out if you would like to speak with an advisor.

* Certified Financial Planner Board of Standards Inc. owns the certification marks CFP^®. CERTIFIED FINANCIAL PLANNER™ and CFP^® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements. The Certified Exit Planning Advisor (CEPA^®) credential is issued by the Exit Planning Institute.

DISCLAIMER: THIS MATERIAL PROVIDES GENERAL INFORMATION ONLY. COLDSTREAM DOES NOT OFFER LEGAL OR TAX ADVICE. ONLY PRIVATE LEGAL COUNSEL OR YOUR TAX ADVISOR MAY RECOMMEND THE APPLICATION OF THIS GENERAL INFORMATION TO ANY PARTICULAR SITUATION OR PREPARE AN INSTRUMENT CHOSEN TO IMPLEMENT THE DESIGN DISCUSSED HEREIN. CIRCULAR 230 NOTICE: TO ENSURE COMPLIANCE WITH REQUIREMENTS IMPOSED BY THE IRS, THIS NOTICE IS TO INFORM YOU THAT ANY TAX ADVICE INCLUDED IN THIS COMMUNICATION, INCLUDING ANY ATTACHMENTS, IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, FOR THE PURPOSE OF AVOIDING ANY FEDERAL TAX PENALTY OR PROMOTING, MARKETING, OR RECOMMENDING TO ANOTHER PARTY ANY TRANSACTION OR MATTER.