The winner of the $1.337 billion Mega Millions jackpot – the second largest in Mega Millions history – still has not come forward. We do know that the ticket was purchased in Illinois, and that the winner has a limited time to claim their prize and make decisions about how to receive it. While they have one year from the date of the draw to claim the jackpot, Illinois rules say they only have 60 days to decide whether to take the winnings in a lump sum or as annual payments.
No matter what the mystery winner chooses, lottery winnings this big have major tax implications. Only 24% of the prize is automatically withheld and sent directly to the government. But the IRS takes up to 37% total in tax. On top of that, many states tax lottery winnings. The winner may not think about paying taxes when they receive their cash, but that additional 13% or more in federal and state taxes will need to come out when they file their next tax return.
For attorneys, earning a contingency fee is a lot like winning the lottery when it comes to paying taxes. The lump sum is reason to celebrate – whether it’s from the Mega Millions or resolving a big case. That is, until tax season comes around, when you’re suddenly in a higher tax bracket and owe a big percentage in income tax.
Although many attorneys come to expect the big tax hit, it doesn’t make it feel any better. But there is one solution that can help attorneys smooth out what is typically an unpredictable flow of income.
Attorney fee deferral, also called attorney fee structure, allows attorneys to receive their fees in periodic payments rather than a lump sum. The arrangements are customizable and are invested pre-tax. Attorneys who defer their fees are only responsible for paying taxes on the payments they receive in a year – not on the whole lump sum. Meanwhile, the rest of the fee grows in a tax-deferred investment account.
Placing a contingency fee into a pre-tax investment account gives an attorney a much higher starting amount to grow, which translates to better earnings overall.
For easy math, compare two attorneys who will each receive a $1 million fee. The first attorney defers the full fee. The second attorney receives the fee in income as a lump sum. Both portfolios are invested with the same investment advisor with the same assumed growth rate of six percent, and both attorneys withdraw $100K annually. The attorney who took the fee in a lump sum, after paying initial income tax, will need to grow the funds for nearly a decade to get back to the original $1 million. Since the attorney who deferred the fee started investing the full $1 million on day one, that deferred fee will yield more than three times the total growth over time as opposed to taking the fee in a lump sum. And the number of distributions from the deferred fee last twice as long as a lump sum.
Your next big fee might feel like you’ve won the Mega Millions, but you might be able to plan smarter for it. Give us a call to discuss fee deferral before the next case settles.