Getting a lump sum of $1 million is no simple matter and figuring out the amount of tax due on it is complicated as well. The answer depends on several factors, including the source of the money, where you live and whether Social Security and other FICA taxes apply. Personal circumstances make a big difference. In fact, the total tax deduction on a windfall gain of $1 million can range from none to most of it. A financial advisor can help you create a comprehensive financial plan that includes tax planning.
Overview of Taxes on $1 Million
You may owe a variety of taxes on the $1 million. Federal income taxes usually claim the largest share, although it depends on how you came up with the $1 million. Capital gains tax, when applicable, will take a smaller part. State income taxes and payroll taxes, if any, usually demand more modest deductions.
Location is extremely important for state income tax purposes. If you live in one of the nine states with no income tax, you don’t owe anything. Other states levy income tax at different rates. Local income taxes may also apply in some cities.
While where you are is a factor, where the money came from matters more, at least most of the time. Inheritances and withdrawals from a Roth IRA or similar after-tax retirement account can be completely tax-free. If the $1 million comes from a gain on selling an asset such as a stock that you’ve held for more than a year, it will likely be treated as a long-term capital gain and qualify for a significantly lower tax rate.
In the worst case, the largest tax deduction typically applies when you earn $1 million in ordinary taxable income, which includes salaries and certain other types of income. Here are some scenarios that outline the possible tax consequences of receiving $1 million under different circumstances.
$1 million tax-free
You can accept up to $1 million without tax in certain situations, including inheritances, insurance and retirement account withdrawals. However, this is not a blanket statement. Sometimes you may owe taxes on any of these possible sources of $1 million.
For example, if you inherit $1 million from your spouse, you don’t owe any federal taxes. Six states tax inheritances from a spouse. These are Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Of the rest, you can typically inherit $1 million tax-free.
You can even cash a $1 million insurance payout check without owing taxes, at least for a while. For example, life insurance settlements typically escape taxation. Also, you usually don’t owe any tax on a settlement for personal physical injury, although you often do owe tax on a settlement that covers emotional injury. Insurance payments for property damage are generally not taxed as long as they do not exceed the exempt tax base of the lost property.
A $1 million withdrawal from a Roth retirement account offers another potentially tax-free scenario. However, exceptions do exist. Some states tax retirement income and early withdrawal of earnings before age 59.5 may result in a 10% penalty in addition to income tax.
$1 million in ordinary income
The worst case scenario from a tax perspective is when you earn $1 million in salary. Tax rules treat salaries, wages, and similar sources as ordinary income that are subject to multiple taxes.
To begin with, you owe federal income tax. For example, if you are unmarried and make $1 million in taxable income, you will be in the highest tax bracket, which is currently 37%. This means that you will pay 37% in federal income tax on the portion of your income that exceeds the limit of the highest tax bracket. You will still owe tax on your income that is below this limit, but you will pay at a lower rate.
In addition to the federal income tax levy, most states collect income tax on ordinary income. The highest marginal rate is in California at 13.3%.
If you make $1 million in salary or self-employment income, you also owe Social Security and Medicare taxes. The Social Security tax rate for employees and employers is 6.2% (12.4% for self-employed individuals) and the Medicare tax rate for employees and employers is 1.45% (2.9% for self-employed individuals).
However, there is a limit on the amount of wages subject to Social Security taxes. In 2023, the limit is $142,800. This means that if you make more than $142,800 in salary or self-employment income, you will not have to pay Social Security tax on the amount above the limit. These scenarios assume that a normal income of $1 million is generated in one year. If possible, you can reduce your tax bill by spreading it over several years.
other sources of income
If you win $1 million in the lottery or gaming at a casino, you will have to pay federal income tax on it because gambling winnings are considered taxable income. The states also take a share of the winnings in gambling. However, you will be saved from FICA taxes on your winning bets.
If the $1 million is from long-term capital gains, such as the sale of stocks or real estate, you’ll pay a lower tax rate than ordinary income. The long-term capital gains tax rate for high income earners is currently 20%. Capital gains and other investment income are also exempt from FICA tax.
In addition to location and income source, your filing status can affect how much you’ll pay in taxes on $1 million. For example, if you are married and file a joint tax return with your spouse, your combined income will determine your tax bracket. If you have children or other dependents, you may be eligible for a tax credit that can reduce your tax liability.
Tax management strategies can also reduce your tax burden. For example, you can choose to donate to charity, receive a tax deduction, and reduce your tax owed. You may also be able to contribute to a retirement account, reducing your taxable income, subject to annual contribution limits.
Several factors can affect how much tax you will pay on $1 million. The source of the money may be most important. For example, you may owe no tax on money received from an insurance settlement or spousal insurance. But if it came from a salary or wages paid to you, especially if you live in a state with a high income tax, you may owe most of your windfall in taxes. Your tax filing status and any tax management strategies can also make a big difference.
Tips for Tax Planning
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