Winning the lottery is perhaps one of the most exciting days of a person’s life, it comes with a huge responsibility. Apart from the relatives, community and other people who will literally hang on you, you’ll also have to pay taxes. After winning the lottery, you are given only 60 days to decide whether you want an annuity which is smaller annual payments or a lump sum which is one check for the single amount of money that you’ve won. Even if you are yet to become winner, it’s still worthwhile to learn something about what taxes have to do with your lottery winnings.
Tax rates for the lottery winnings
When it comes to taxes, lottery winnings are usually taxed depending on the federal tax brackets. This means you may not pay the same tax rate on the whole amount. Since the tax rates are progressive, it means that parts of your winnings are usually taxed at different rates.
Depending on the number of lotteries that you’ve won, you may pay up to 37% of your winnings as taxes. Local and state taxes also vary by location. While some states do not impose an income tax, others usually withhold almost 50% of taxes. Plus, some states have withholding rates for no residents. This means that even if you reside there, you may still have to be taxed.
The first thing that you need to do is to decide whether you’ll take an annuity or a lump sum. The tax perspective on taking annuity will reduce your tax liability for that year by putting you in the lower tax bracket. However, there are high chances that in the coming years, the taxes that you pay may go up. It’s, therefore, advisable to take the lump sum if you win a lottery or any other mega millions.
Although at first, it might seem like less money, if you go the annuity way, the lottery is only expected to pay you 4.5% of your money every year. This means it may take you several years to receive all your earnings. If you go the lump sum way, make sure you hire a financial advisor to avoid making the kind of mistakes that most winners usually make.
Benefits of taking up a lump sum against an annuity
One of the best things about taking a lump sum is that you have more control over your money. You can decide to invest it in other stock option or into a retirement account to generate some income. You could also use it to expand your business or to buy an asset.
According to several financial advisors, you need to take a lump sum because you’ll typically enjoy higher returns on investing the winnings in assets such as stocks. Overall, the decision for which option to take is a bit complex. It just depends on your current and projected interest rates, the size of your winnings, where you live, and the potential rate of return on any investment.
The taxes that you’ll pay with an annuity
If you opt for annuity payment, they will tax every installment that you pay. This means, every year you’ll still owe the government a lot of money.
The taxes that you’ll pay with a lump sum
Usually, the amount that you’ll pay is 25%. As compared to what you owe the government, this is typically less. You, therefore, need to file returns and report your winnings to the IRS. Your filling status, whether single, married, or jointly will determine the amount of tax that you’ll be required to pay.
Common terms used in lottery taxation
• Withholding taxes– If you win more than $5000 in a lottery, 24% of your winnings must be withheld for tax purposes. This means you will be given a W-2G that shows the number of lottery winnings paid to you during the year and the amount of tax that’s withheld.
The payor will also send the same information to the IRS. You must give the payor your social security number. If state income tax withholding is needed, the amount of withheld tax may also be included in form W-2G.
• Estimated taxes– Since your tax rate can even be as high as 37%, which is more than 24% of the amount withheld; the amount may not be enough to cover all your taxes. If this is so, you are required to make estimated tax payments in advance. If you fail to do so, you may be penalized. Besides, you may owe local and state income taxes, which may require you to make local and state tax payments.
• Shared ownership of winning a lottery– If you are sharing the prize with other people, you may still end up being taxed on the whole amount depending on how you are going to share the winnings. The idea is to determine if the lottery ticket was owned by different people before it was declared the winning ticket. If you can be able to do this, the co-owners of the ticket will only report their individual shares.
• Sale of rights to lottery instalment payments for a lump sum- There are lottery companies who will choose to pay a lump sum in exchange for the winner’s rights future payments by . If you are in such a transaction, you must include this as the income that you receive as the normal income.
• Estate tax– In case you are entitled for annual payments, there is a possibility of dying before the end of the payout period. If that’s the case, the present value of the unpaid installment will form part of the estate. This may, therefore, lead to estate tax. However, since these have not been paid, your estate may not have money to pay the taxes on the includable amount.
But if you give way part of your winnings or you cannot prove co-ownership, you will pay tax on the full amount of the winnings. Plus, it will be assumed that you’ve made a gift on the part of the prize. Depending on the value of the gift and other circumstances, the gift tax may even be up to 40%. You also need to be aware that the IRS may question the validity of the ownership, especially if all of you are from the same family. In such a case, it’s important to confirm that the co-ownership arrangement was properly set up before you became winners.
Five tax tips for lottery winners
When you realize that your ticket has been picked as the winning ticket, you are likely to freak out a lot. Here are five quick tax tips that will help you deal with your new income.
• Consult or hire tax professional– By hiring a tax pro, you’ll be able to get an overview of the tax issue that you are likely to face. Your trusted expert will play a very important role in helping you work through the other things.
• Decide how you want to be paid– Depending on where you are, you’ll have months to decide whether you want to be paid a lump sum or as 30 annuity payments over the next 29 years. Your tax pro will help you understand the costs based on what you’ve chosen.
• Choose a team of legal and financial advisors– Regardless of how you take your income, you are probably going to pay a lot of tax. Your tax pros as well as your accountant, attorney, and an investment advisor will help you sort out through the legal and financial issues of dealing with large sums.
• You need to consider the gifts carefully– With all the new income that you have, you may want to share a bit of it with friends, charity, and family. You should, therefore, know the effects that the gift could have on you and the amount of tax that you will pay.
• Add up all your gambling losses– Just like all the other things you need to know all your gambling loses to use the winnings to offset the loses.
Final words
It’s no doubt that winning the lottery can dramatically change your life. A financial income of that state may quickly give you a level of freedom that you couldn’t have imagined. However, becoming a mega-millionaire or lottery winner doesn’t change everything in your life.
If you are lucky to be a winner, you’ll still have to worry about paying taxes and taking care of your bills- more particularly the taxes on your winnings. That’s why it’s important to get up to speed with all the information concerning taxes and the lottery. Thankfully, the above information should help you know how to go about your taxes when you win a lottery.
