If you’re one of the millions of people who play the lottery, you probably just think about what you’ll do with all the money if you win. However, if you’re lucky enough to win big in Powerball, Mega Millions, or another lottery, there’s something else you’ll need to think about: taxes.
The federal and most state governments consider lottery winnings to be taxable income—they are taxed as ordinary income, just like the income you earn from a job. How much tax you’ll have to pay on your winnings depends on your total income and the state where you live. As a rule of thumb, you can expect to lose almost half of your winnings to taxes. That means that after taxes the three winners of the $1.5 billion Mega Millions lottery will walk away with a mere $250,000,000 each.
Lottery winners have the option of taking their winning in a one-time lump sum payment, or having them paid in the form of an annuity. With an annuity you’re paid a little at a time over many years—anywhere from 20 to 40 years. For example, let's say you just won a million dollars in the Powerball lottery. If you select the annuity option, you’ll be paid $33,333 per year for 30 years. However, you’ll have to pay income tax on the payments each year. After taxes, you can expect to receive only about $20,000 per year (assuming tax rates are about the same in the future as they are now).
If you take your money in a lump sum, you’ll receive a single payment of $620,000—this is equal to the present cash value of the 30-year annuity. However, after taxes, you’ll be left with only about $375,000. In fact, it’s about one-third of the promised million dollars.
You’ll can save on taxes by taking an annuity because, depending on your other income and the annuity amount, it may not be subject to the top income tax rate (currently, 37%). A large lump-sum payment would be taxed at the highest rates.
Not only do you have to pay taxes to the federal government on your lottery winnings, you may also need to pay state income taxes as well. Not all states tax lottery winnings. Of course, they are tax free in those states that don’t have any income taxes at all: Texas, Florida, South Dakota, Wyoming, Washington, New Hampshire, and Tennessee.
However, a few states that have income taxes exempt state lottery winnings from taxes. These include California (for tickets bought in-state) and Pennsylvania. In Arizona, up to $5,000 in state lottery winnings are tax exempt. In Oregon, state lottery winnings of up to $600 from a single ticket or play are tax exempt.
As a general rule, if you live in one state and win a lottery in another, you're first taxed by the state where you bought the lottery ticket. Then, if your home state has the same or a lower tax rate than the other state, you won't have to pay taxes in your state. If your state's tax rate is higher, you'll get a "credit" for the taxes you paid to the other state and pay the difference to your state. In some states, state tax rates on lottery winnings differ for residents and nonresidents. For example, Arizona residents pay a 5% tax on lottery winnings, while nonresidents pay 6%.
Lottery winnings over $5,000 are subject to both federal and state income tax withholding—this is, part of your winnings are automatically paid to the IRS and state tax agency by the state lottery agency. The lottery agency must withhold 25% of your winnings for federal income taxes. How much is withheld for state income taxes varies from state to state, ranging from a low of 3.40% in Indiana to 8.82% in New York. If you’re paid an annuity, the withholding is taken out of each check.
Although 25% federal withholding may seem like a lot, if you win big, it may not cover your total tax liability. Right now, the top federal tax rate is 37%--way more than 25%. This rate applies to individuals with over $500,000 in taxable income, and $600,000 in income for marrieds filing jointly. So big winners who take lump-sum payments could end up owing taxes even after 25% is withheld from their winnings. You should set some of your money aside to pay these taxes.
Lottery winnings over $600 are reported to the IRS by the lottery agency using IRS Form W2-G, Certain Gambling Winnings. This is an information return used just for gambling. It will show the amount of your winnings and the amount of any tax that was withheld. The lottery agency will send a copy of the form to the IRS and your state tax department. You file copies with your federal and state income tax returns.
Many people purchase lottery tickets as a group, such as an office lottery pool. However, in most states only one person can be named as the payee on the lottery ticket. This person should not claim the lottery winnings as an individual and then distribute them to the other members of the pool. Doing so could make him or her individually liable for the entire tax due on the winnings. Moreover, gift taxes might have to be paid when this person distributes the pool members their shares. To avoid these calamities, the members of the pool should form a legal entity such as a partnership, limited liability company, or trust to claim and distribute the prize. Each pool member will then pay his or share of tax on the distributions.
Many big lottery winners give away substantial sums to friends and family. There is nothing wrong with this. However, you should be aware that a federal 40% gift tax applies to some types of gifts you make while you’re alive. You, the giver, must pay this tax, not the person who receives the gift. Fortunately, it’s easy to avoid this tax. You can give away up to $11.180 million to people other than your spouse (if any) before you become subject to the gift tax. Moreover, you can give up to $15,000 per year to as many individuals as you want without it counting against the $11.180 million exemption.
