Don’t let tax bill surprise you
Q: I was appalled to discover that I owed money to the IRS when I filed my 2020 tax return, despite following instructions line by line. What do I do to prevent this discrepancy from happening again?
A: If you unexpectedly owed money to IRS when you filed your 2020 return, or your refund was too small or large, consider checking your withholding.
The IRS has a tax withholding estimator on its website to help individuals figure out whether they are having the right amount of income tax withheld, say from their paychecks or retirement distributions. The online tool asks about various sources of income in addition to wages, and it also provides tips on tax credits and various deductions. It estimates how much additional or less withholding, if any, people should request.
Retirees should keep in mind this popular income tax withholding strategy: Tax withheld at any point in the year is treated as if evenly paid throughout the year. Some retirees rely on this rule to have taxes they expect to owe withheld from an RMD. Retirees who are falling short on their tax withholding should have more federal income tax withheld from a yearend IRA distribution. You could also hike withholding from Social Security, pension or annuity payments.
Q: Are settlement proceeds received from an attorney malpractice suit taxable?
A: Yes. In a recent case, a woman sued her divorce attorney for malpractice, alleging he was negligent in representing her in a divorce. The parties later settled for $175,000. She claimed the settlement was nontaxable, arguing that but for the lawyer’s negligence, she would have received more tax-free money in her divorce. The Tax Court disagreed, saying the settlement agreement made clear the payment was in lieu of claims arising out of the legal malpractice lawsuit.
Successful litigants are generally taxed on their gross settlement or award without reduction for attorney fees. In the case described above, the lawyer who represented the woman in the malpractice lawsuit received the $175,000, deducted his $73,500 in attorney fees, and sent her a net check of $101,500. The full $175,000 is taxable to her. In the past, nonbusiness-related legal fees were generally deductible on Schedule A as a miscellaneous itemized deduction, subject to the 2%-of-Adjusted-GrossIncome threshold. The 2017 tax reform law nixed this class of writeoffs, so now individuals generally cannot deduct these attorney fees.