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Understanding windfall taxation

When someone wins a large sum of money, whether it’s from a game show, lottery prize, or a social media challenge, like those organized by MrBeast, it’s considered a windfall.

In the U.S., windfalls are subject to federal income tax, and often state taxes, too — meaning Alex won’t actually take home the full dollar amount of his winnings. It must be reported to the Internal Revenue Service (IRS) by filing an individual tax return.

The IRS treats prize money as regular income, which means it’s taxed at the same rate as wages or salaries. Here’s a breakdown of how the taxation might work:

Federal taxes: The federal income tax system is progressive, which means an individual pays more in tax as their income rises. Taxable income brackets range from 10% to 37%.

The taxable income brackets break down as follows:

  • 10% — $0 to $11,600
  • 12% — $11,601 to $47,150
  • 22% — $47,151 to $100,525
  • 24% — $100,526 to $191,950
  • 32% — $191,951 to $243,725
  • 35% — $243,726 to $609,350
  • 37% — $609,351 or more

In this case, Alex would owe 10% on the first $11,600, 12% on the portion from $11,601 to $47,150, 22% for the portion from $47,151 to $100,525, etc.

State taxes: In addition to federal taxes, Alex may also owe state income taxes, which varies widely across the country.

In some states, like Florida and Texas, there’s no state income tax, while others, such as California, have rates as high as 13.3%. Assuming an average state tax rate of 6%, Alex would owe an additional $27,000.

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Reducing your windfall tax liability

While it’s impossible to avoid taxes on windfalls altogether, there are several tactics winners can consider to mitigate their tax liability:

Charitable donations: Donating a portion of the winnings to charity can help reduce taxable income. The IRS allows deductions for charitable contributions, which can lower the overall tax burden. However, the amount deducted must be itemized and the charity must be recognized by the IRS.

Retirement accounts: Contributing to tax-advantaged retirement accounts, such as a 401(k) or IRA, can also reduce taxable income. For instance, in 2024, individuals can contribute up to $22,500 to a 401(k) and up to a maximum of $7,000 for a traditional IRA (or $8,000 for those 50 and older). Contributions could lower the taxable income.

Tax credits: Taking advantage of various tax credits, such as the Earned Income Tax Credit (EITC) or the Child Tax Credit (CTC), can also help. These credits directly reduce the tax bill rather than just the taxable income.

Spreading the income: In some cases, it might be possible to spread the income over multiple years, thereby potentially lowering the overall tax rate. This can be a more complex process and may require careful planning and consultation with a tax professional.

Consulting with a tax professional: Given the complexities involved in managing a large financial windfall, consulting with a tax professional is a smart move. A certified public accountant (CPA) or a tax attorney can provide tailored advice and help the winner navigate the tax implications.

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Chris Clark Freelance Contributor

Chris Clark is freelance contributor with MoneyWise, based in Kansas City, Mo. He has written for numerous publications and spent 18 years as a reporter and editor with The Associated Press.

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