Your Lottery Dream…Crushed by Taxes
By Ashley Khan, CPA
When you think of winning the lottery, you dream of what your new life will be like and the things you will buy – houses, cars, yachts, planes, etc. Chances are you don’t think about the taxes that you will owe on those winnings, and that can catch many lucky winners off guard.
The reality is that lottery winnings are taxed as ordinary income for both federal and state purposes, although there are a handful of states that do not tax lottery winnings. Generally, if you win more than $5,000, Federal, as well as state taxes, will be withheld from your winnings. The problem is that the Federal withholding rate for lottery winnings is 24%, but the highest Federal tax bracket is 37%. Depending on how much you win, that gap can result in a massive tax bill. If someone wins the lottery in January, the tax return for that year is due almost a year and a half later. Many times, the winner has spent all or most of their lottery winnings by that time, but could still owe a large tax liability that they weren’t properly planning for.
Depending on how much you win, the type of payout that you select can greatly impact the amount of taxes that you pay. You can elect to receive the payment in a lump sum or annuity payments each year, which is generally paid over 30 years. You are taxed on the winnings when you actually receive them. Therefore, if you select the annuity option, you will be taxed on a portion of the winnings each year for 30 years. For most jackpots, if you select the lump sum option, you will fall in the highest tax bracket. However, if you decide on the annuity payments, you could fall into a lower tax bracket for each of the years that you receive payments. This can result in significant tax savings, and it can help winners better manage their money rather than having the option to spend it all in a couple of years.
The lottery is not the only way you can end up with a surprise tax bill. Let’s say you go on a popular game show and you get called to “come on down.” If you have some luck on this game show, you can end up winning a car, vacation, new home gym and matching his and hers watches. What you may not know is that after taking all of your prizes, you will receive a statement from the game show with the total value of all of your fancy prizes to be included in your income on your tax return. Unlike the lottery, you didn’t receive money, allowing you to put some aside and pay your upcoming taxes. You can do several things to reduce or eliminate these taxes, such as selling or donating some of the prizes to charity. You could also simply not accept all of the prizes from the game show.
Next time you don’t win the record breaking, billion dollar lottery jackpot, be thankful that you don’t have to worry about paying taxes on those winnings!