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The odds of winning Powerball are 1 in 292.2 million. As noted in this nifty outlook on the matter, we all have significantly shorter odds of being struck by lightning or dying by way of bee sting. Sure, the odds are “better” on the various state lotteries, but the point is winning the lottery isn’t the typical way one comes into financial windfall.
Likewise, there are long odds of finding a Mickey Mantle rookie card at a garage sale or other fanciful wealth creators of that nature. However, there are more frequent, plausible windfall creators that advisors and clients encounter. Those include a scenario in which a client is heavily invested their employer and that company gets acquired and of course, old fashioned inheritance.
In almost all cases, windfalls are positive, but they’re also unexpected. Acknowledging the latter point and the challenges associated in planning for such events, advising clients on windfalls is reactionary, but it’s better than taking no action at all.
Time to Talk Taxes
An obvious way in which advisors can assist clients is to provide tax services – in-house if applicable or refer clients to CPAs. Regardless of how a windfall is accrued, there are likely to be tax implications. Take the cases of clients that sold businesses.
“Proceeds from the sale of a business, for example, are taxed at short- or long-term capital gains rates, which can be as much as 40.8% for those in the highest tax bracket,” notes Scott Hiller of Charles Schwab. “However, if you sold qualified small business stock (QSBS) and you held the shares for at least five years, you may be able to exclude anywhere from 50% to 100% of any gains from your tax liability. If you didn't hold the assets that long, you may be able to defer taxes by reinvesting the gains in a new qualified business within 60 days.”
Likewise, many advisors are likely to have a few clients that realized substantial windfalls by selling equity a company they founded or a firm at which they’re employed. Those are taxable events and nearly all clients dealing with a windfall generated in this fashion need the help of accountants and advisors. After all, they’d like to mitigate their tax exposure as much as possible.
“If your wealth comes in the form of company stock, you might be on the hook for two forms of tax: ordinary income tax at the time the shares vest and capital gains tax when you sell the shares,” adds Hiller. “The taxation of equity compensation ultimately depends on the type of stock award you receive, so consider consulting a tax specialist who can help you strategize the best way to liquidate your holdings.”
Inheritance Implications
Broadly speaking, inheritance is the most frequent way in which clients come into windfalls and it’s one that can somewhat be planned for. Still, an inherited windfall often calls for an advisor’s expertise because clients may not be aware of the myriad tax issues they’re about to face.
Say a client’s parents pass and leave the client a house that the parents paid $200,000 for, but it’s worth $1 million today. When the client sells the house for $1 million, they’re paying capital gains on $800,000, not the original purchase price of the property.
Clients that inherit retirement accounts face different circumstances, particularly if they’re nonspouse heirs. One example of why an advisor is needed in this scenario is the required minimum distribution (RMD) age. A nonspouse client inheriting a 401(k) or an IRA has to take annual RMDs and deplete the account within a decade.
“An heir may be exempt from the 10-year distribution rule if they are the minor child of the account owner, 10 or fewer years younger than the account owner, or disabled or chronically ill as defined by the IRS,” concludes Hiller. “Inherited Roth IRAs, too, must be depleted within a decade and may be subject to annual RMDs—assuming the holding period requirements have been met—but heirs will not owe any tax on the withdrawals.”
Bottom line: windfalls are great, but that influx of capital is even better when the recipient has the right advisor supporting them.
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