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Don't Gamble With Taxes

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By Roy Lewis
September 20, 2002

Many people, myself included, consider the lottery to be little more than a tax on the ill-informed. But, from time to time, some of you are lucky enough to win a shilling or two in your favorite lottery. How will that affect your taxes? Let's take a quick look.

How lottery winnings are taxed
First, know that your lottery winnings are taxable. This is the case for cash winnings and for the fair market value of any non-cash prizes (e.g., a car or a vacation). Depending on your other income and the amount of your winnings, your federal tax bracket can go as high as 38.6%.

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. In short, you're stuck. But you can be happy knowing that, in the words of "Fast" Eddie Felson, money won is much sweeter than money earned. And paying taxes on money won is a bit easier to deal with than paying taxes on those wages that you worked so hard to generate. But let's also see if there are ways that we can take a bicuspid out of that tax bite.

Gambling losses
You're entitled to a tax deduction for any gambling losses you incure. These are taken as an itemized deduction, but your losses can't exceed your winnings. In other words, if you report no gambling income, you'll get no benefit of gambling deductions. 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 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. For those who decide to take their lottery winnings over a number of years, those future payments are also considered gambling winnings, which will allow for the deduction of gambling losses in future years. 

One final warning on gambling deductions: They might not be all they're cracked up to be. You can't simply "net out" your winnings and losses and report that net figure on the front of your tax return. Instead you must report your entire winnings as income, and use your losses as itemized deductions. But what if you don't have any other itemized deductions? Will your gambling losses do you any good? Perhaps not, since your standard deduction will be greater than your gambling losses. But the winnings might have a significant impact on your total taxes and may cause you to pay additional taxes (such as making some of your Social Security earnings taxable when they otherwise wouldn't be). So don't automatically think of your gambling losses as a tax-savings vehicle.

When lottery winnings are taxed 
Report your windfall in the year the prize (be it cash or a car) is received -- regardless of when you might have won it. 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.

Consider the lucky person who wins the lottery in December of 2001. But because of delays in presenting the ticket to the authorities and administrative time to actually issue the payment, the check was not given to the winner until January of 2002. Regardless that the actual win took place in 2001, the income isn't reported until 2002.

If you win more than $5,000 in the lottery, 27% 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.)

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 38.6%, which is well above the 27% they will withhold for large winnings, the amount of tax withheld from your lottery winnings might not 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. If you think this might apply to you, read up on the rules about prepaying your taxes. But, more importantly, there are loopholes at your disposal that will spare you, so make sure you check out the estimated tax penalty exceptions.

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 your office-mates, for example, 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. And just because this transaction is considered a sale doesn't mean you'll receive capital gains tax treatment (and a lower tax rate). The IRS would treat this transaction as nothing more than a discounted present value of an ordinary income stream. That being the case, the sale would produce ordinary income, and would not be considered a sale of a capital asset.

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 ensure 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 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 ticket to me, and let me deal with all of these messy tax issues.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns, as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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