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Taxes and the Lottery

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By Roy Lewis

Many people, myself included, consider the lottery to be little more than a tax on the ill-informed. However, I have received a number of questions about lottery winnings recently. Here's a brief rundown on the tax implications of winning the lottery.

How lottery winnings are taxed

First, you should be aware that your lottery winnings are taxable. This is the case for cash winnings and for the fair market value of any noncash prizes you might win (e.g., a car, vacation, etc.). Depending on your other income and the amount of your winnings, your federal tax bracket can go as high as 39.6%.

Your lottery winnings might also be subject to state income tax. Thus, depending on where you live, your total tax bill could exceed 50%. You don't get any capital gains rate break for lottery winnings, nor is there any income averaging to help lower your tax bill.

Gambling losses

On the other hand, you are entitled to a tax deduction for any gambling losses you had. These are taken as an itemized deduction but can't exceed your winnings. Gambling losses aren't subject to the 2% floor on miscellaneous itemized deductions, nor are they subject to the 3%-80% overall limitation on itemized deductions. When you gamble and lose, you should keep documentary evidence of your ticket purchases (canceled checks, credit card charges, losing tickets, etc.). In some cases, taxpayer estimates have been allowed, but you shouldn't rely on this -- documentary evidence is preferable by far.

When lottery winnings are taxed

You would report the income in the year, or years, the winnings are received. In the case of noncash prizes, this would be the year the prize is received. In the case of cash winnings, the year you report the winnings would depend on whether the lottery prize is payable in installments, or whether you are given the option to elect payment in a lump sum.

If a state lottery prize is payable in installments, you must include the annual payments and any amount designated as interest on the unpaid installments in income, as received. If you elect to receive payment of a state lottery prize in a lump sum, you must include the entire lump sum in income in the year received.

Withholding

If you win more than $5,000 in the lottery, 28% 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. (This information also gets sent to the IRS by the payor.)

You must give the payor your Social Security number. The payor might use Form W-9 to request this information from you. If you fail to give the payor your Social Security number, 31% will be withheld.

If state income tax withholding is required, the amount of state income tax withheld might also be shown on Form W-2G.

Estimated taxes

Since your federal tax bracket can go as high as 39.6%, which is well above the 28% they will withhold for large winnings, the amount of tax withheld from your lottery winnings might not necessarily be enough to cover your tax bill. On top of your regular tax liability, you could be assessed an additional penalty for failure to make estimated tax payments during the year. Thus, you might also have to make estimated tax payments in advance. For a more-detailed discussion of the estimated tax issue, check out on that very issue in the Taxes FAQ area.

Assignment of lottery ticket

If you are sharing the winnings, you could still wind up paying tax on the entire amount, depending on the sharing arrangement. The key is to establish that the assignment of all or part of a lottery ticket took place before you won. That is, if you simply win and then give away part of the winnings, you will be taxed on the full amount and will be treated as having made a separate gift (which, depending on whom you gave it to and the amount, could itself be subject to gift tax).

But, if you and another individual(s) agree to share the ticket before it turns out to be a winner, then you each report only your share in income. Note that, if the person you claim to have shared the ticket with is a family member, the IRS might question the validity of the sharing agreement.

Assignment of lottery winnings payable in installments for lump sum

Several companies are in the business of acquiring lottery winnings that are payable in installments from prizewinners in exchange for a discounted lump sum. If you assign your right to future lottery installments to one of these companies for a lump sum in an arm's length transaction, the assignment is treated as a sale. You would have to include the lump sum in income in the year of the sale.

Divorce situations

If a divorce court requires a lottery winner to turn over a portion of the periodic lottery winnings to his or her spouse, the lottery winner must take great care to insure that the court recognizes the winner's tax burden when deciding how much must be turned over.

In one case, for example, a lottery winner agreed to turn over half of his yearly lottery payments to his ex-spouse, but neglected to take into account that he still had to pay income tax on the entire amount of each installment he received. If you find yourself in divorce proceedings and are still playing the lottery (is this called "double jeopardy"?), be very, very careful.

Estate tax

If you win a very large amount, the proceeds might be payable over a period of years -- for example, equal payments over 20 years. If you die early in the payment period, the present value of the proceeds payable after your death would be includable in your estate, but your estate might not have the cash to pay the tax on that includable amount.

Proper planning can avoid this problem. If you are fortunate enough to win a sizable lottery prize, I strongly recommend that you review your entire estate plan.

Or, you can make your life much easier and simply give the winnings to me. :-)
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