How to Handle a Windfall When You Have to Pay Taxes

By Elizabeth Rosen

NEW YORK (IRS.com) — When you get a windfall — whether it’s an inheritance from a relative, winnings from the lottery or gambling or proceeds from a legal settlement — you may be anxious to start planning how you will spend that money.

But before you get too far ahead of yourself, you need to remember that you may owe federal taxes on the sum.

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As soon as you learn that a significant sum of money is coming your way, consider consulting with a qualified tax professional about the tax implications of your new wealth. In many cases, inheritances, gifts from family members or friends and life insurance payouts are tax free to the recipient. Federal taxes may be owed by the giver or by the estate from which the inheritance is received though. It is also important to take into account any state or local taxes, which may differ from the IRS rules regarding federal taxation.

Inheriting an Individual Retirement Arrangement

If you inherit a traditional IRA from your spouse, there are usually three options you can choose from:

  1. You can treat the inherited IRA as your own by designating yourself as the account owner.
  2. You can treat the inherited IRA as your own by “rolling it over” into your IRA or (to the extent that it is taxable) into a.) Qualified employer plan, b.) Qualified employee annuity plan, or a Section 403(a), c.) Tax-sheltered annuity plan, or a Section 403(b), or d.) Deferred compensation plan of a state or local government, or a Section 457.
  3. Rather than treating the inherited IRA as your own, you can treat yourself as the beneficiary.

If you inherit an IRA from someone other than your deceased spouse, the IRS will not allow you to treat it as your own IRA. Therefore, you are not permitted to make contributions to the inherited IRA or “roll over” any amounts. Instead, you may consider setting up a trustee-to-trustee transfer so you can be treated as a beneficiary of the inherited IRA, which means you won’t have to pay tax until you start receiving distributions. Or you can opt to withdraw the money as a lump sum and pay all of the income taxes due in that year.