Taxation of Lottery Winnings
Taxation of Lottery Winnings
There are several tax considerations when winning a lottery, as well as important nontax considerations, you should take into account.
How lottery winnings are taxed. Lottery winnings are taxable for both cash winnings and for the fair market value of noncash prizes, such as a car or vacation. Depending on your other income and the amount of your winnings, your federal tax rate may be as high as 37%. Your lottery winnings may also be subject to state income tax. Thus, depending on where you live, your total tax bill could be as high as 50%, or more. You do not get any capital gains rate break for lottery winnings, nor is there any income averaging to help lower your tax bill.
On the other hand, you are entitled to a tax deduction for any gambling losses you incurred. These are taken as an itemized deduction, but cannot exceed your winnings. If your lottery winnings are payable in annual installments, the installments you receive in future years are still gambling winnings, making losses in those future years deductible to the extent of the installments, even if you have no other gambling winnings in those years. Gambling losses are not subject to the pre-2018/post-2026 2%-of-adjusted-gross-income floor on miscellaneous itemized deductions (miscellaneous itemized deductions are suspended for tax years 2018-2025), nor are they subject to the pre-2018/post-2026 overall limitation on itemized deductions (also suspended for tax years 2018-2025).
To establish your entitlement to a deduction for gambling losses, you should keep documentary evidence of the costs of your wagers which would include both the cost of your lottery tickets and of any other wagering you do, such as betting on races, casino games, etc. The evidence should consist of receipts for tickets, wagers, cancelled checks, credit card charges, losing tickets, etc. Make sure you do this for all the years for which you are receiving installment payments of your lottery winnings. In some cases, taxpayer estimates have been allowed, but you should not rely on this. Documentary evidence is preferable by far.
When lottery winnings are taxed. You report your lottery winnings as income in the year, or years, you actually or "constructively" receive those winnings. In the case of noncash prizes, this would be the year the prize is received. In the case of cash winnings, if you are required to take the winnings in annual installments, you only report each year's installment as income for that year.
If you can choose between a lump-sum payment and a series of installment payments, when your winnings are taxable depends on when you made that choice. If, as is the case with most state lotteries, you had to make the choice when you bought the ticket, you include your winnings in income only when you actually receive them. In that case, if you chose the lump-sum arrangement, you must include the entire lump sum in income in the year received. If you chose the installment arrangement, you must include the annual payments and any amount designated as interest on the unpaid installments in income as received.
On the other hand, if you have already won and you can still choose between a lump-sum payout and installments, please call so that we can discuss which choice is better for you.
Withholding. If you win more than $5,000 in the lottery, 24% must be withheld from your winnings for federal income tax purposes. You will receive a Form W-2G from the payor showing the amount of lottery winnings paid to you during the year and the amount of federal income tax withheld. The payor will also send this information to IRS. You must give the payor your social security number. The payor may use Form W-9 to request this information from you. If state income tax withholding is required, the amount of state income tax withheld may also be shown on Form W-2G.
Estimated taxes. Since your federal tax rate can be as high as 37%, which is well above the 24% withheld, the amount of tax withheld from your lottery winnings may not be enough to cover your federal tax bill. If this is the case, you may need to make estimated tax payments in advance and you may be assessed a penalty if you fail to do so. In addition, you may owe state and local income taxes which may require you to make state and local estimated tax payments. We can help you determine if you should be making estimated tax payments and how to avoid any late payment penalties. Please call so that we can review your payment situation.
Shared ownership of winning lottery ticket. If you are sharing the prize on a winning lottery ticket (for example, with family members or friends), you may still end up paying tax on the entire amount, depending on the sharing arrangement. The key is to establish that the ticket was owned by multiple persons before the ticket was declared to be a winner. If you can do this, the co-owners of the ticket each report only their individual shares as income.
If you cannot prove co-ownership or if you give away part of your winnings, you will be subject to income tax on the full amount of the prize. In addition, you will be treated as having made a gift of the part of the prize that you give away, and you may be subject to a separate gift tax on this gift. The gift tax may be as much as 40% of the gift, depending on the amount of the gift and certain other circumstances.
Be aware that IRS is likely to question the validity of a claimed co-ownership arrangement if the co-owners are all members of the same family. In that case, it is especially important to be able to establish by documentary evidence that the co-ownership arrangement was properly set up before the lottery ticket became a winner.
Sale of rights to lottery payment installments for a lump sum. There are companies that will pay a lump sum to lottery winners in exchange for the winners' rights to future installment payments of their lottery winnings. If you enter into such a transaction, you must include the entire lump sum you receive as ordinary income (not capital gain) in the year of the transaction.
The amount of any lump-sum payment offered to you depends, at least in part, on a "discount rate" that is ordinarily determined by negotiation. A discount rate is an interest rate that is used to determine how much a series of installment payments is worth right now. A lower discount rate means a larger lump sum for you now; a higher rate means a smaller lump sum now.
If you have been approached by one of these companies, please call us before you accept any offer. These offers require careful evaluation to determine their fairness. We can help you determine if it is in your best interests to sell your rights to future lottery prize installment payments for a lump sum and, if so, help you negotiate the best deal possible.
Divorce situations. If you have won a lottery while married and later divorce or separate from your spouse, you must exercise great care in determining how your lottery winnings will be treated or you may suffer severe tax consequences. For example, in one case, a lottery winner entitled to receive his prize in annual installments agreed to turn over half of each annual installment to his ex-spouse, but did so in a way that left him liable for income tax on the entire amount of each installment. If you find yourself in divorce proceedings, we can alert you to all the tax consequences involved and advise you how to best protect your interests.
Estate tax. If you are entitled to receive annual installments of a lottery prize over several years, it is possible that you will die before the end of the pay-out period. In that case, the "present value" of the unpaid installments will be part of your estate. This may cause your estate to be subject to estate tax or may significantly increase the amount of estate tax due. However, because these unpaid installments have not been paid yet, your estate might not have the cash to pay the tax on the includable amount. Proper planning can avoid this problem. Also, the estate tax may be reduced by the method used to value the unpaid installments (for example, by taking a discount to reflect state-law restrictions on your right to transfer your interest in the payments).
If you have been fortunate enough to win a sizeable lottery prize, we strongly recommend you review your entire estate plan, especially in light of changes to the estate tax in the Tax Cuts and Jobs Act passed in 2017. We would be happy to work with you to be sure that you minimize any potential estate tax problems.
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