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Scratching a lottery ticket

Paying Tax on Lottery Winnings

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Shan-Nel S.Verified

Tax Professional & Owner

Tax and Law

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Deducting Gambling Losses

Even wins as small as $1 should be reported to the IRS, but you can deduct gambling losses to help offset taxes on any winnings.

Whether you are playing a scratcher ticket or the Powerball, winning the lottery is exciting and potentially life-changing. After the initial excitement subsides, you may be wondering what happens next.

If your lottery winnings are significant, you probably owe Uncle Sam a hefty sum. Since cash lottery prizes are taxed as income, you may also owe state taxes. Understanding how lottery gains impact your taxes helps you manage your winnings effectively. In turn, smart management gives you the freedom to decide how you will spend it.

A lottery scratcher

Claiming lottery prizes

The way you report your winnings depends on the prize amount. For example, you do not have to fill out special paperwork to claim prizes under $600. However, the Internal Revenue Service (IRS) still expects you to track and report the prize on your tax return. Higher prizes are subject to more scrutiny and withholding taxes.

Winning $600 or more

If you win over $600, you must fill out a claim form. It includes IRS Form W-9, a request for your Taxpayer Identification Number (TIN). In most cases, your TIN is the same as your Social Security number. You must also report your gambling winnings on Form W-2G, Certain Gambling Winnings.

It can take up to several weeks to claim lottery prizes over $5,000. The federal government withholds a 25% tax on cash amounts that fall into this category. If you do not provide a valid TIN, the percentage withheld goes up to 28%.

Non-cash prizes are also subject to a 25% withholding tax, calculated on the fair market value (FMV) of the prize. When the payer takes care of the withholding tax, the amount jumps to 33.33% of the FMV. However, the winner does not have to pay the higher withholding tax.

Calculating withholding tax

The federal government withholds taxes on lottery winnings based on the amount you won, minus the amount of the wager. In other words, if you spend $100 on lottery tickets and win $5,500, the IRS only uses $5,400 to calculate withholding tax. In this case, your withholding tax would amount to $1,350.

Just because the government withholds 25% of larger payouts does not mean you have fulfilled your tax obligations. Very large prizes, such as Powerball winnings, can bump your income into a higher tax bracket. If your winnings put you into the top bracket, you will pay nearly 40% of it in income tax.

For example, if you win $1 million, you will pay nearly $400,000 in income tax. Since the government only withholds 25% of lottery winnings, you will still have a tax bill of about $150,000.

Lump sum vs. annuity payments

With large payouts, you have two payment options: either receive a lump sum or get annuity payments for a set number of years. There are pros and cons to both payment methods. If you settle for a lump sum, you will receive the “cash value” of the prize. This is about half of the lottery’s advertised value. On the other hand, annuity payments often last for 20-30 years. Older winners may not live to see their last payment.

The way you choose to receive your prize also determines how you will pay taxes on it. Lump sum payments can be handled on a single tax return, with only one tax bill. Annuity payments are taxed as they are paid out, and can bump regular income into a significantly higher bracket.

Which payment method is best?

Many tax professionals recommend taking a lump sum payment. Tax law changes frequently, so the tax you pay on this year’s annuity payment may be higher next year. However, there is not a single answer that is right for every situation. The best payment amount will depend on many factors such as filing status, overall income, other non-lottery winning losses or deductions in recommending the best payment method for the year. This is usually something that is determined on a case-by-case basis. It is important to get insight from legal and financial Experts who can help determine which option is right for you.

Paying state taxes 

In addition to paying federal taxes on your lottery winnings, you may also have to pay state income tax. The rates vary from state to state. New York’s tax rate is the highest at nearly 9%. Indiana is at the other end of the spectrum with a 3% tax rate.

The states that do not levy an income tax

If you live in certain states, you are in luck. These states do not levy an income tax.

  • Alaska
  • Florida
  • Nevada
  • New Hampshire
  • South Dakota
  • Tennessee
  • Texas
  • Wyoming

California and Pennsylvania residents also get a tax break. As long as you purchase tickets in-state, your lottery winnings are tax exempt. However, out-of-state winners in Arizona and Maryland may fare differently. Both states withhold taxes on lottery prizes for out-of-state winners.

Municipality taxes

Some municipalities impose an additional tax on lottery winnings. For example, New York City residents must pay nearly 4% in municipality tax. It is a good idea for urban residents to check local tax laws after a win.

Filing a tax return for lottery winnings

The time frame for claiming a winning ticket varies by state. You have anywhere from 180 days (about six months) to a full year to claim your ticket. When you claim your ticket is just as important as the payout method you choose. You must pay taxes on the winnings in the year in which you claim them.

To put this into practical terms, imagine you buy a winning ticket in November of the current year. If you claim it in December, you must include the information on this year’s tax return. On the other hand, if you do not claim it until January or later, your lottery winnings will be filed on next year’s return.

Filling out your return

If you have lottery winnings to report, you must use Form 1040 to file your taxes. It is also referred to as the long form since Forms 1040-A and 1040-EZ are much shorter. You will also need any WG-2 forms you received during the year. There should be one for each payment. Remember, you must self-report amounts under $600, even if you don’t expect to pay taxes on them.

IRS form 1040

You should report your lottery winnings on line 21 of Form 1040. If you are receiving annuity payments, the amount you report will be for a single year. Do not forget to include any regular income for the year. If you itemize deductions, you can subtract any gambling losses for the year from your winnings. However, your losses cannot exceed the amount you won. You must have substantiating documentation for any losses claimed.

Once your return is filled out, double check it for accuracy and submit it to the IRS. Make sure you include copies of any supporting documents. The IRS has up to seven years to audit a return; retain your records for at least that long.

Taking advantage of tax breaks for lottery winners

If you have always wanted to fund a charity, now is the time to do it. Charitable giving offers one of the biggest tax breaks to lottery winners. You may donate up to 50% of your income to qualified organizations. Make sure you donate to a registered 501(c)(3) organization. You may want to spread out gifts over several charities or set up a trust. A verified tax Expert can review choices with you in a customized, one-on-one conversation. You can even be anonymous if you wish.

charity donation jar

Most lottery winners get excited and often go on outlandish spending sprees. These frivolous sprees often take the winner down the road to ruins. Instead of following in their footsteps, invest those winnings in a low-risk mutual fund. Many people do not even realize that they could invest in a low-risk mutual fund and live off the interest alone. Let’s say you win $100 million after tax, and you invest the winnings into a diversified mutual fund, you could earn approximately $2 million a year after taxes.

Investing as much as legally allowed into tax-incentive savings IRAs and college savings accounts helps reduce income and avoid paying high taxes on the lottery winnings. However, keep in mind, there are age-based limits on contributions.

Winning as a group

Many states only allow one payee per ticket. This can significantly impact your taxes if you are claiming the prize on behalf of a group. It is advisable to create a partnership, trust, or other legal entity to represent each member of the group before turning in a winning ticket. If one person claims the winnings and distributes them, he or she may be responsible for the taxes on the entire sum. The claimant may also have to pay gift taxes for each distributed portion of the prize.

When you claim lottery winnings as a group, you will fill out IRS Form 5754. The form asks for the name, contact information, and amount received for each group member. The lottery commission uses this information to prepare separate WG-2s for each person. Each one will use the WG-2 they receive to report their portion of the winnings on their tax return.

Trusts and partnerships have different rules for their formation. They are also handled differently for tax purposes. If you need to distribute lottery winnings among a group, talk to a legal Expert. They can help you determine the best strategy for sharing your prize.

Giving your winnings away

Generous lottery winners often want to share their good fortune with friends and family. However, you may only give up to $14,000 per person each year. Any amounts over that are subject to gift tax. If you are sharing money with family members who will eventually inherit your estate, you may be able to give more. But you must keep track of gifts because they will count against the estate exemption when your beneficiaries inherit.

Just as with group winners, it is wiser to form a legal entity for distribution purposes. Get the facts from a tax or legal Expert before you claim your ticket to avoid paying excessive taxes.

Navigating challenging situations

Emotions often run high during major life events like a divorce or the death of a family member. Adding lottery winnings to the mix can have huge tax implications. For example, you could split winnings with an ex-spouse, but still be responsible for both tax portions. Or if a recipient dies before all annuity payments are made, their estate may be responsible for tax on the unpaid portion. It is important to review your options both before and after claiming a winning ticket.

Navigating a substantial lottery win takes careful planning and logical choices. Although the necessary structure can be intimidating, setting up the right structure gives you the freedom to have fun with your winnings.

Talking with a tax professional about your choices is a helpful way to make sure you’re prepared to tackle some of the likely hurdles in accepting a large sum of money.

Protecting your privacy

After you have signed the back of your ticket, the next thing you should do is keep quiet. Keep your new-found wealth to yourself until you get things in place. The next thing you should consider doing is delete all social media accounts. Since lottery winners are public knowledge and are generally published by the media, it will not take long for your secret to be out once you turn in your ticket.

However, before turning in your ticket, hire an attorney that specializes in lottery winnings to set up a blind trust. This will help keep your name private. The blind trust will have its own name to ensure your anonymity.

Once you have turned in your ticket and received your money, you can then open up about your winnings to your family and friends. Even at this point, it is best advised to not draw attention to yourself. Even the most careful person will eventually star in the limelight; give yourself some time for the reality to set in before attracting undue attention.

To work or not to work?

Whether you continue to work or you quit your job is a question only you can answer. However, it is advised to keep your job or switch to that career you have always dreamed of having. Continuing to work, regardless of where or what is a good way to stay grounded and humble. Also, it will help pay a few taxes and may even help you save some of the money you have just won.

Man working on tablet

Now may even be the time to go back to school. Not only will you develop your education, but tuition costs are tax deductible as well.

Paying off debt vs spending sprees

Now that you have enough money just itching to be spent, pay off that debt that troubles you. Hold off a bit on buying extravagant purchases. Think the purchase through; how much will the taxes be? How will the asset depreciate? Many lottery winners first purchases are usually houses and cars. Remember, all things expensive require costly upkeep and maintenance.

Many of us dream of winning that giant pit of lottery money. We daydream of happier days living – less debt, fewer worries. But does winning the lottery make anyone any happier?

Of course, there will be the high-flying, mood-boosting moments when realizing you just won a ton of money. In one study that was done, approximately 75% of people that won the lottery admitted to that sudden rush of happiness because of financial freedom. About 22% stated they had seen no real difference in their happiness. They were happy before the lottery, or the lottery did not make a huge impact on their mental state. However, 3% said that winning the lottery ruined them, acknowledging that money cannot buy happiness and admitting that they felt miserable with the pressures of sudden wealth.

In all actuality, how you handle the new wealth will determine your level happiness after winning the lottery. Armed with the right information, you should do just fine.

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