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Suppose that Alice ordinarily makes $100,000 a year. Then, in Year 1, she wins the lottery and experiences a one-time windfall of $2.4 million, bringing her income for that (single) year up to $2.5 million. Suppose she lives in a state with a flat 5% income tax. Then between January 1st and April 15th of Year 2, she pays her federal income tax and also $125,000 in state income taxes for the huge windfall in Year 1. Her income goes back to the usual $100,000 in Year 2. Now when it comes time to pay taxes for Year 2, she can deduct the $125,000 in state taxes that she payed in Year 2, which is more than her entire income that year. Wouldn't that mean that she she runs a net operating loss for individuals in Year 2?

It seems funny that any one-time windfall that increases your income to about 20 times its usual level should almost automatically lead to a "net operating loss" the following year, simply because your income returns to normal. Am I misunderstanding Alice's tax situation?

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I think there is some confusion about when state taxes are paid and deducted. You would be listing the state taxes paid on the windfall the same year that you deduct those state taxes from your federal return, which reduces your federal taxes owed on the same windfall.

Your taxes the next year shouldn't generate a net operating loss, because even though the payment is occurring in the following year, you are paying the tax bill for a prior year, and it already reduced your federal tax liability for that year, so you can't deduct it twice.

Edit: Yes, technically you could generate a net operating loss by not paying your state income taxes until the following year, but you would then lose that deduction in the year where it will help you the most (the windfall year will bring you up to a 39.6% marginal rate, so that deduction of $120,000 will save you $47,520 if you pay it the year of the windfall, vs. $26,582 the following year (assuming filing single to give you the best case scenario of tax savings) for a savings of $20938 by paying in the year you received it.

  • State income taxes get deducted for the year they're paid, not for the year the income was earned: ttlc.intuit.com/questions/…. So if Alice waits until Year 2 to pay her taxes for Year 1, then she can't deduct those state taxes from her Year 1 tax bill, which covers the taxes on the windfall. – tparker Mar 17 '17 at 17:28
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    If you make quarterly payments on the state taxes owed for the following year, you can deduct them. Your marginal tax rate is much higher in the year that you receive the windfall, so why would you not pay the state taxes during the year of the windfall? Save 39.6% on your federal return for the windfall year vs. saving 25% during your normal income year. – Nathan L Mar 17 '17 at 18:23
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    @tparker marginal rates only apply to the income earned above the dollar amount that puts you in the higher bracket. If you have a deduction high enough to give you a net operating loss, then only some of the money you are paying the next year will be taxed at the top rate, the rest of the money you earn before the top marginal rate will be taxed at lower marginal rates. – Nathan L Mar 17 '17 at 18:55
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    Both fed and state normally require withholding or quarterly payments on income as you earn it. When you file your taxes you pay the difference between the actual amount owed and the estimate, but that's expected to be a relatively small percentage. Lottery winnings are no exception: the feds and most states get withholding tax: they take their cut before you get a penny. – Jay Mar 17 '17 at 20:21
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    @Jay there is a safe harbor rule with allows you to pay quarterly payments at the rate of what you earned in the previous year. Lotteries are a special case where the state will get the withholding, but other windfalls as covered in this scenario might not have anything withheld. – Nathan L Mar 17 '17 at 21:16

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