Taxes When You Receive a Large Bonus or Windfall

Receiving a large sum of money — whether a year-end bonus, an insurance settlement, a legal award, an inheritance, or a lottery prize — can be exciting, but it comes with tax consequences that can be more significant than people realize. Planning ahead is key to keeping as much of it as possible.

The most straightforward impact is that a large sum of income in a single year can push you into a higher marginal tax bracket. The good news is that the U.S. uses a progressive tax system, meaning only the income above each bracket threshold is taxed at the higher rate — your entire income doesn't suddenly get taxed at the top rate. However, a large bonus can also trigger phase-outs of deductions and credits that were otherwise available to you, the 3.8% Net Investment Income Tax on investment income if your income crosses the threshold, and Medicare premium surcharges (IRMAA) two years down the road. Doing a mid-year tax projection when you know a large income event is coming helps you understand the full impact.

If you receive a large bonus from your employer, ask your employer's payroll department how they plan to withhold taxes on it. Employers can use two methods: the aggregate method (adding the bonus to your regular wages and withholding at your marginal rate) or the supplemental wage method (flat 22% federal withholding for bonuses up to $1 million). If your marginal rate is higher than 22%, you may be under-withheld on a bonus. You may want to make an extra estimated tax payment to cover the shortfall and avoid underpayment penalties.

Legal settlements deserve special attention because the tax treatment depends entirely on what the settlement is compensating you for. Settlements for physical injury or physical sickness are generally tax-free. Punitive damages, even in a physical injury case, are taxable. Emotional distress damages are taxable unless they arise from a physical injury. Back pay and lost wages in discrimination cases are taxable as ordinary income. Interest included in any settlement is always taxable. Getting the tax treatment of a settlement right — including potentially having the settlement agreement specify the nature of the damages — can make a significant difference in the after-tax amount you receive.

For very large windfalls, consider strategies to spread the tax impact or defer income where possible. If the windfall is from a sale of business assets or other property, an installment sale agreement can spread the gain over multiple years. If you receive a large amount of appreciated stock or property as a windfall, contributing some of it directly to a donor-advised fund or donating it outright to charity can both eliminate the capital gains tax and provide a large charitable deduction. A large-income year is also potentially a good year for a Roth conversion if you're going to be in a high bracket regardless, as the conversion adds less relative pain at the margin.