Can The Windfall Tax Affect You?

The windfall tax is deceptively simple. When you receive 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 you received.

As soon as you learn that a significant sum of money is coming your way, consider consulting with a qualified tax professional about the potential 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. However, federal taxes may be owed by the giver or by the estate from which the inheritance is received. It is also important to take into account any state or local taxes, which may differ from the IRS rules regarding federal taxation.

How Windfall Taxes Work

You know windfall taxes happen when someone or something gets a whole lot of money, but what are they really? Simply put, windfall taxes are a specialized form of taxes that the federal government imposes on entities going through a period of unusually high financial gains, referred to as a “windfall”. While the causes for this windfall can be many, the most common are market fluctuations or the discovery of natural resources; even a change in government policy that favors the growth of a particular industry can bring about windfall taxes.

The idea of windfall taxes is to generate significant revenue to fund government programs that benefit society at large, but in practice they’ve proven to be quite controversial and the source of many debates over the years. Not only that, but industries and corporations aren’t the only entities that can be subjected to windfall taxes; individuals can also be hit with them.

Windfall Taxes On Individuals

Like we mentioned at the beginning, windfall taxes can also be applied to individuals who have acquired significant amounts of money through gifts, inheritances, or as prizes from gambling, the lottery, and even game-shows. While some of those are normally tax-free (to the recipient), others will be subject to taxes since they’re considered taxable income.

In the same vein, individuals who have earned a considerable amount of money as a settlement from a lawsuit will likely owe a part of that money in taxes. It depends, really, since some settlements are considered non-taxable (such as those from personal injury cases), but many others are considered regular taxable income.

The following are all common scenarios of individuals faced with windfall taxes.

Inheriting an IRA (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 [Section 403(a) Plan], c.) Tax-sheltered annuity plan [Section 403(b) Plan], or d.) Deferred compensation plan of a state or local government [Section 457 Plan]
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 that 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.

Lottery or gambling winnings

Any winnings that you receive from playing the lottery or gambling are fully taxable and must be reported on your individual income tax return. It is important to remember that lottery and gambling winnings are considered taxable income (not capital gains) by the IRS.

The IRS has divided the types of gambling into four main categories:

1. Horse Racing, Dog Racing, Jai Alai, and Other Similar Wagering Transactions
2. Sweepstakes, Wagering Pools, and Lotteries
3. Bingo, Keno, and Slot Machines
4. Poker Tournaments

If you wish to claim gambling losses on your federal tax return, keep in mind that your losses must be reported separately as itemized deductions, not simply subtracted from your winnings. In claiming this tax deduction, remember that your gambling losses may not exceed your winnings. If your gambling or lottery winnings exceed specified amounts, you will receive Tax Form W-2G (Certain Gambling Winnings) from the IRS.

Use IRS Form W-2G (Certain Gambling Winnings) to report any gambling winnings, as well as any federal income tax that is withheld from those winnings.

NOTE: If you win a lottery prize that is payable in installments, on your tax return you are required to report both the annual payments and any amount designated as interest on the unpaid installments.

You should file Form W-2G if any of the following situations apply to you:

• Your winnings (not reduced by the wager) are $1,200 or more from a bingo game or slot machine,
• Your winnings (reduced by the wager) are $1,500 or more from a keno game,
• Your winnings (reduced by the wager or buy-in) are more than $5,000 from a poker tournament,
• Your winnings (except winnings from bingo, slot machines, keno, and poker tournaments) reduced by the wager, at the option of the payer, are $600 or more and at least 300 times the amount of the wager, or
• Your winnings are subject to Federal income tax withholding (either regular gambling withholding or backup withholding tax).

“Regular gambling withholding” refers to the withholding tax that applies to gambling winnings. You are required to withhold 25 percent of your gambling winnings for Federal income tax if your winnings (minus the wager) exceed $5,000 and are from lotteries, sweepstakes, wagering pools, or other wagering transactions (if your winnings are at least 300 times the amount you wagered). Additionally, in some cases your gambling winnings may also require state taxes to be withheld.

Legal Settlements

If you have won a lawsuit and have been awarded a monetary legal settlement, you are likely to owe Federal taxes on it. While certain settlements (such as damages for personal physical injuries or physical sickness) are considered non-taxable by the IRS, most other types of damages are taxed as ordinary income.

Types of damages that may be subject to Federal tax include the following:

• Certain types of settlements for personal physical injuries or physical sickness
• Proceeds received for emotional distress or mental anguish
• Settlements from an employment-related lawsuit
• Settlements for lost profits from your trade or business
• Property settlements for loss in value of property (above a certain threshold)
• Interest on any settlement (generally considered taxable as “ordinary income”)
• All punitive damages (should be reported as “other income”)

Note that you may be required to make estimated tax payments if you are the recipient of a legal settlement. Additionally, in many cases, the percentage of the settlement that goes to your attorney will count as your taxable income. For more information, see IRS Publication 525 (Taxable and Nontaxable Income).

The Controversy of Windfall Taxes

As you know, taxes on their own are a hot button issue for a significant percentage of the population. That divide is even bigger when it comes to discussing policies such as windfall taxes, with those against them arguing that (much like taxes themselves) they reduce a company’s profit seeking incentive, and that any profits from windfalls should be reinvested back into the industries themselves. Arguments in favor revolve around using the money to address inequality and fund government programs that benefit society, as well as functioning like a stabilizer of the economy in general.

Individual windfall taxes are equally controversial, but since it’s mostly seen as a personal nuisance rather than having industry-wide consequences, the debate is mostly left alone.

Conclusion

Suddenly receiving a windfall can be very exciting, but don’t forget to consider the Federal and state/local tax implications of coming into that much money. For specific advice regarding your unique circumstances, consider hiring a qualified tax professional and/or financial planner.

While controversial, and unlike corporate windfall taxes, individuals are unlikely to see any respite from them any time soon. Earning a large amount of money is very exciting, sure, but it’s equally shocking to suddenly see an IRS notice in your inbox or your mail because you failed to report the amount on your tax return. So get smart about them!

Windfall Taxes: Frequently Asked Questions

1. What are windfall taxes?

Windfall taxes are a special type of tax imposed on companies (and individuals) experiencing unusually high financial gains (mostly due to circumstances beyond their control, such as market highs or the government rolling out a new, favorable policy).

2. Why does the government impose windfall taxes?

In paper, the U.S. government imposes windfall taxes to address the inequities of companies or individuals benefiting “disproportionately” from economic conditions that are not their own doing. Whatever is gathered from windfall taxes is then invested into public programs or relief funds.

3. What industries are the most commonly targeted by windfall taxes?

All industries can be targeted by windfall taxes if the perceived windfall is substantial enough, but they’re most commonly applied to industries where fluctuations are significant:

• Oil and gas companies when energy prices reach unusual highs.
• Mining companies when the prices on commodities surge.
• Utilities going through unexpected spikes in profits.

4. Do windfall taxes become permanent?

No, windfall taxes are supposed to be temporary measures and are only levied by the government when market conditions for a particular industry is exceptionally favorable, and are kept only as long as these profits are high; when market conditions stabilize themselves, then the windfall tax is phased out.

5. What are some recent examples of windfall taxes?

In the U.S., the most recent example of a windfall tax imposed by the government was the Crude Oil Windfall Profit Tax Act back in 1980. It was created by the administration of Jimmy Carter, along with Congress, to catch some of the windfall experienced by the oil industry caused by the spike in prices after the OPEC oil embargo. Elsewhere in the world, some European countries have used windfall taxes as recently as 2022.

6. Are individuals subject to windfall taxes too?

Yes. Individuals can be subjected to windfall taxes by the federal government, although not in the same way as corporations. When someone gets an inheritance, wins the lottery, or even hits a big score gambling, and makes an unusually high amount of money, they can be taxed by the government; some of those instances are still considered tax free, but in the rest, you have to report that money as ordinary taxable income.

---