I hear it all the time: “I paid the taxes on that and I’m not going to pay taxes on it again.” Gambling wins, retirement and 401k withdrawals, legal settlements, bonuses for selling plasma, and other payments have the taxes held out.
Often, I have clients that are resistant to list these payments on their taxes for fear of having to pay twice. Having taxes held out gives the illusion of having paid the taxes on that money already. Putting it on their tax return feels like double taxation. However, taxes held out are not taxes paid.
How Taxes Work
The US has graduated income tax brackets. The more you make, the higher rate of taxes you pay. If you are low-income, you might not pay any income taxes. If you are high-income, you pay more. All your income goes into the same pile and then it is taxed.
Example: A taxable interest settlement from a class action lawsuit. A low-income person, after adding the settlement to their W2 and unemployment, is still low income and doesn’t owe any tax. The interest was taxable, but their tax rate is zero. However, a high-income person gets the same small settlement, but that goes on top of the pile with 2 W2s, dividends, stock options, capital gains, partnership income, and more. Their interest settlement is taxed at 24%. You make more money; you pay more taxes.
Pay-outs and Taxes
When you get a taxable payout, whether it is from a lawsuit, the casino, retirement funds, selling plasma, or something else, they give you the option to have the taxes held out. You pay the taxes and forget about it, right? WRONG! You still need to report it to the IRS.
How does the casino, lawyer, or bank know how much to hold out? Do they know the rest of your income situation? Do they know if you get Earned Income Credit or Child Tax Credit? Do they know if your spouse makes six figures? No. They do not know any of that and that is not their job to figure it out. It is their job to hold out some money and deposit it with the government instead of giving it to you.
So, how much do they hold out? Generally, a flat 20%. If you are subject to taxes in your state, they hold out 5% for state taxes. That’s it. If you are low income, it is too much. If you are high-income, 20% will not be enough. Too much or too little is not the bank/ casino / lawyer’s problem. That’s your problem. You have to file a tax return in the Spring to figure it out.
But I Paid the Tax, I’m Not Paying Again
Exactly, you are not. You report all your income together on your tax form in the Spring. When you add all your income together, you figure out how much your total tax is. Just like the examples above, your payment is not taxed separately. It is added to all your other income and you are taxed based on your total income.
However, you also report all the money that you already paid. Whether it was on your W2, or held out from one of your payments, you get credit for ALL the money held out when you file your taxes.
Reporting your income on your tax forms is not paying again, because you haven’t actually paid yet. Filing your taxes is calculating your bill for the whole year based on all your income. Making payments ahead by having taxes held out is like putting your tax bill on lay-a-way. You make payments in advance, then you figure out the bill in the Spring. Then you might get some back or you might owe more.
Wait, I Might Owe More?
It is possible that the 20% withholding is not enough. Three examples:
- If you got a large payment, it is added to your other income, and it could put you in a higher tax bracket.
- Having over $25,000 in other income while collecting Social Security can make your Social Security taxable.
- Taking money out of retirement can trigger a 10% early withdrawal penalty, which means the taxes are even 10% higher on that withdrawal.
There are many possibilities where the flat 20% taxes held out may not be enough to cover your actual tax bill.
What Happens if I Don’t Report It?
Failing to report income is a big deal to the IRS. They have copies of all the forms you received and know about your payments. However, they are big and slow and it takes about 18 to 24 months to reconcile all the payments with what you reported. About two years after you make the mistake is when they finally come after you. That payment you received is long gone and now you owe two years of penalties and interest for failing to report all your income.
Tips
- Be sure to report ALL your tax documents on your tax return every year: all 1099s from gambling, retirement withdrawals, lawsuit settlements, and any other taxable payments.
- If you get a substantial payment during the year, be sure to do your taxes early to see if you owe so you can make arrangements.
- If you are not sure what to do, contact an Enrolled Agent (like me) or get help on IRS.gov
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More on tax issues for regular folks:
Your Manager Cannot Take your Tips (video)
What’s All This Stuff Taken Out of my Check?
