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Congratulations if you got it. You’ll find the answer on our website. Congratulations also to Melanie Amaro, with the angel voice, winner of the X-Factor. Read on to find out how to solve some puzzles about windfall earnings, like those Melanie Amaro will receive.
A $5 million dollar contract and the opportunity to launch a recording career. What a gift! She earned her top spot and it is a very large amount of overnight wealth for anyone to receive. A recent article by Robert Frank, “The Truth About Wealth” in the Wall Street Journal, December 17, 2011 refers to a Federal Reserve study on the top 1% of income earners (those earning over $343,000 in 2009). The study revealed that 60% of the super wealthy did not remain in the top 1% of income after a couple of years. Wealth is hard to hold onto.
You may not have just won the X-Factor, but you might receive a large settlement, inheritance, lottery, bonus or stock option. Just in case, pay attention before you take any action to maximize the wealth available to you over your lifetime.
Scenario #1 - No Plan
If the winner of a $5,000,000 lottery or game show or bonus or stock option lived in California (Melanie is lucky since Florida has no income tax), without planning, the winnings would be taxed at the highest combined rate. California tacks on 10.5% plus the 35% federal rate, makes a top 45.5% income tax rate. This would reduce the amount available to the winner to $2,725,000. If the winner wanted to be conservative and only use the income from this remaining amount to live on, they might be able to invest to earn $136,250 annually, which is then taxed a bit over 30%.
Many people do not have competent legal or investment advice, but instead use the winnings to fund the family gifts, toys and fun that we all love to imagine. In that case, most of it the windfall is gone within approximately 5 years. Remember, income from inheritance or legal settlements is income taxable, but the principal is not. Windfall earnings or lottery winnings are taxed at the highest possible income tax rate in the year they are paid.
Scenario #2 - Structured Payments
If Melanie is lucky, her winning contract will pay her a set monthly amount at a level that will keep her tax rate below 30%. Given a 5% annual investment rate, she could see approximately $144,0000 per year for 20 years, which is approximately a $5,000,000 present value contract. With no tax deductions, this would leave her with $103,680 in annual income over twenty years. While not the millions it seems at first, this type of settlement effectively guarantees income for life at a lower tax rate than taking the entire amount immediately. Also, this type of structure offers a base “safety net” of income should Melanie’s singing career not provide her with a steady income. Structured settlements are often used in personal injury settlements. Often a neutral 3rd party trustee is named to handle a litigation special needs trust for the benefit of the injured party. In the case of windfall earnings or winnings, if the payment can be taken over time, the temptation to spend it all is reduced and the tax rate can be reduced.
Scenario #3 - Give It Away
While the winner of $5,000,000 does not save in income taxes by creating a charitable trust with the winnings, if a large lump sum is received from inheritance, winnings, or un-exercised stock options, charitable trusts can be used to save the estate from paying estate taxes. This is especially useful when low basis assets are re-valued upon the death of a parent. This scenario can also save the estate from losing value by avoiding capital gains taxes if properly handled.
If someone receives a large inheritance, many estate planning attorneys will recommend placing some or all assets into a charitable trust. If an employee receives stock options and the value of the stock dramatically increases, a great strategy can include a charitable trust to obtain income and lock in values. The charitable trust can be set-up to give assets to a church or other charity near to your heart. The trust manages the money and passes on the income to you until death, when the charity receives the assets.
Word to the wise: if you anticipate or receive a windfall payment or have stock options you want to exercise, it pays to see a qualified, competent estate planning attorney who can help you coordinate with other professionals to lower taxes and help you maximize your windfall. Otherwise, you might be the subject of the above proverb.
Merry Christmas to all and to all a good night!!
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