Sudden Wealth Syndrome Mistakes that Erode Wealth and Invite Taxes
You’ve encountered a sudden, drastic increase in your wealth. It could’ve happened in a number of ways. For example, an inheritance of a multi-million dollar fortune, a lottery award-money, high stock returns, a compensation from life insurance coverage, or a lump-sum distribution from retirement accounts.
The million dollar question here is: how do you avoid impulsive mistakes and keep that wealth from dissipating?
Here are the three mistakes that you, as a victim of the Sudden Wealth Syndrome (SWS), may commit that calls for tax implications and the strategies to come out of the situation unharmed:
Syndrome #1 Sudden Impulsive Decisions
You’ve become a millionaire overnight by winning one of the top prizes in the Powerball game.
Astronomical amount of wealth can overwhelm you. You probably aren’t habituated to manage such a huge amount of money and so, don’t have the necessary tools to safeguard them. People around you have little or no experience and are willing to double up as your financial advisor and well-wisher, even without you asking for it. They may tell you about the smartest objects to buy, share Zen-like investment ideas and even guide you to behave as someone from the genteel class, or better still, what kind of charity or social work to get associated with.
You may also have to deal with absurd requests from people asking for gifts or loans. The bottom line is you’re in a muddle where everyone wants a share of the pie. This could be terrible and sometimes, depressing to handle. Your whole experience after the financial windfall will be one that of a New Year’s party till you see your fortunes dwindle and you’re in a state of constant rumination.
Not paying taxes on your financial windfalls like lottery-winnings and making too many undocumented purchases, loans and gifts to avoid taxes invites Uncle Sam’s attention.
What the Uncle Sam says
Lottery winnings like any ordinary income is taxable, both at the federal and state, and sometimes, even at the local level.
As far as federal taxes are concerned, most states apply taxes on lottery winnings of more than $5,000 and taxes are withheld automatically. Tax withholding rates differ from state-to-state and the individual income taxes aren’t necessarily tracked always.
Give yourself a break from all the hullabaloo. When it becomes tough to handle, stop making any decisions about money altogether for sometime. Take time to analyze the alternatives you have at your disposal, seek an expert’s advice if necessary and keep a check on your emotions towards your financial affairs. Retain your home, your job, and most importantly, retain your relationships without making any sort of commitment. Postpone all your financial activities, unless you have a concrete investment or financial plan at hand.
Syndrome #2 Mixing Wealth and Status
According to some financial experts, most self-made billionaires lead a modest life and are always happy to spend less. But, if you’re smitten by the sudden wealth bug, then you could confuse splurging like a headless chicken with being wealthy and importance. The symptoms are manifestations of the distorted American lifestyle that feeds on the glamour and bling of the so-called ‘Rich and Famous’.
These potent images that are shown on television and movies equate material possessions, multi-million dollar mansions, and inflated lifestyles as attractive and attention-grabbing. It’s a catch-22 situation where you need to have a clear understanding of what separates wealth from income and vice-versa. Both the values are starkly opposite to each other. Your choice of a lavish lifestyle can jeopardize your actual financial stability and hence, your capacity to keep your growing wealth from tanking.
Binging on luxurious properties without bothering to pay the necessary real estate taxes.
What the Uncle Sam says
Nationwide, 1.31% is the median property tax rate. In other words, if you buy a home with $2 million, your yearly overall property tax would approximately be $26,200. In case of a $5 million home, it will be around $65,500 and the tax for a $10 million mansion would almost be $131,000.
For example, if you buy a property in Illinois worth $2 million, then your annual property tax would be $47,200 more than it would have been in Hawaii.
You need to decide whether or not you would like to see yourself rich 10 years later, or you’d prefer sitting around a beach of oblivion and bankrupt. The question here is: Do you need a luxurious condominium at an upscale locale, or is your current home working fine for you? Will it be wise to retire so young or do you still have some years of wealth-generating work left in you? Is owning a Ferrari like your neighbor more important than quitting your ungratifying job? Whatever choices you make, the results will keep trickling in for the rest of your life.
So, if your choice is to remain rich, you need to make your alter ego understand that obsession over status will ruin your wealth that way you can move more towards wealth generating activities.
Syndrome #3 Harping on Pre-Tax, Instead of After-Tax Wealth
This part is crucial, if you’ve gained massive amounts of wealth through your assets inviting scrutiny from Uncle Sam. Assets generating wealth are subject to tax before the money can be used by the owner. For instance, wealth generated by stock options, incentive stock options (ISOs), and non qualified stock options that are earned by employees of the companies are taxable. Moreover, retirees receiving one, large retirement distribution, or beneficiaries of an estate with tax-deferred annuities or retirement plans are also taxed by the Internal Revenue Service (IRS).
Minting large amounts of money out of your investments, with no mention of them on your tax returns.
What the Uncle Sam says
If you’ve earned a dividend from stocks, you will be taxed at the rate of 15%, or else, 20% if you belong to the high-income group, at the end of the financial year.
Moreover, you’ll have to pay a 15% tax on the profits made out of selling a stock and 20% if you’re a high-earner. The profits made are called capital gains and the taxes you’re obligated to pay on them is called capital gains taxes. But, if you sell off your stock options before holding it for less than a year, then you’ll have to pay your regular income tax rate on the profit. And mind you, it’s rate is more than the capital gains tax.
Similarly, if you’ve earned dividends from stock mutual funds, then you’ll have to pay taxes for that as well.
The foremost prudent step from your end should be to understand the tax implications of your assets inside out. Get the help of a tax expert, if need be. Calculate how much pre-tax amount you need to have to gain a certain amount of after-tax capital that you’d spend, considering the tax costs of liquidating assets.
You should exercise your stock options only under three circumstances: Consumption, diversification, or alteration in your employment status. No matter what, stick to your resolution of spending from your after-tax wealth. There’s no point in exercising your non-qualified stock option without shedding off your underlying shares. It’s important to note that your up-front taxes (e.g.: taxes applied to stock option exercises) are taxes from just a part of the tax puzzle. You need a robust tax management plan that you monitor and update for the rest of your life.
Final word from the Uncle Sam
You live like a king but claim yourself to be poor. Such a gimmick can land you into serious trouble with Uncle Sam. Yes, you can always claim to have rich and generous relatives, however, if you can’t prove it, you could still get caught in the rut. Remember your tax man has heard every story in the book that you can ever fathom.
Taxes are undoubtedly complex, and you can be in the delusion that anything can be labelled as an innocent mistake. Just don’t do it, ever. There’s a clear distinction between deliberate and non-deliberate mistakes, specified in the tax law. You could be slapped with a huge penalty or get prosecuted for your blunders. The same goes for undeclared income, one that you’ve either stashed underneath your mattress or in a Swiss bank account.
The irony is, almost everything in the U.S. is considered as income and hence, must be taxed. However, there are some incentives in the guise of tax deductions that you can always look forward to as an eager beaver. Still, you need to tread with caution as innocent mistakes can be forgiven, but not intentional unfair means used to dupe the IRS.
Blindly relying on others can be dangerous, so be careful. It’s the most crucial lesson out here but you’ll have to believe in your tax planner, nevertheless.
Andy Masaki is an editor with Oak View Law Group and contributes specifically on personal finance topics. You can also find him fielding queries based on money management topics at various online communities and social media platforms.