A Basic Overview of Taxes for Lottery Winners

Introduction

Taxes can be confusing for anyone. When you win a lottery jackpot, it can seem like there is an endless set of rules that you have to understand. What’s more, it can be difficult to find knowledgeable help that you trust.

At thelotterylab.com, we consistently encourage lottery winners to seek professional advice on legal, financial, and tax matters. Not only are rules and laws constantly changing, but also the circumstances of each individual make it impossible to develop a single solution for everyone. However, we also know that having a basic understanding of issues can make your winning experience more comfortable and successful.

With that in mind, this article covers some basic information about taxes that lottery winners need to know. These include the differences between the lump-sum and annuity options, the way in which taxes are calculated, the details of federal and state taxes, and the role of “reciprocal agreements” between states. This article primarily focuses on income taxes which have to be dealt with shortly after winning a lottery. It does not cover long term issues like taxes on investments, property, or inheritance rules.

The Difference Between Lump-Sum and Annuity Options

Lotteries that offer multi-million dollar jackpots typically offer winners a choice between a lump-sum payment and an annuity that pays a portion of the prize every year for 20-30 years.

Winners are often surprised when they discover that the lump-sum payment is only a fraction of the jackpot that was offered. Many people wrongly believe that the reason the lump-sum payment is lower is because of taxes. In fact, the real reason is that lottery operators usually advertise the “total cash value” of the annuity instead of the “present value” of the annuity. For a more complete discussion see https://blog.thelotterylab.com/understanding-lottery-annuities.

Some Tax Basics

Before we get into the details of taxation, it helps to understand how most governments structure their tax systems.Two important aspects are WHAT is measured to determine the tax and HOW the tax is applied

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    In the United States and most states, the primary source of tax revenue is income. However, income can be calculated in several different ways. Some examples of income include the money you receive from working at your job, and interest or dividends you get from your investments and gambling winnings. Not every taxing authority uses the total amount of someone’s income as the taxable amount. That can be to the winner’s advantage, but, as we will show, this can also create some problems if improperly managed.

    In most cases, a “progressive” system is used so that people earning more income pay higher taxes than people earning less income. Consider the imaginary country of SimpleLand whose progressive tax structure is shown in the table below.

    Income Tax Rate
    $1 to $10,000 10%
    $10,001 to $100,000 20%
    $100,001 and up 30%

    Now let’s consider a resident of SimpleLand named Otis who makes $50,000 a year. Otis owes 10% on the first $10,000 that he earns and 20% on the remaining $40,000. So in total he owes $1,000 + $8,000 = $9,000 in taxes.

    You might recognize this tax structure as being made up of “tax brackets.” Another SimpleLand resident named Martin earns $98,000 a year and complains to his co-workers about “moving into a higher tax bracket.” He frets about suddenly experiencing a dramatic increase in taxes. Martin’s concern is a by-product of misunderstanding tax brackets.

    Right now, Martin pays $18,600 in taxes ($1,000 + $17,600). If his income rose to $102,000, he would pay $19,600. That is, he would pay $1,000 for the first $10,000 he earns, $18,000 for the next $90,000, and $600 for the final $2000.

    Martin’s fear of “moving into a higher tax bracket” comes from his misunderstanding of how the system works. He worries that he will be charged 30% on ALL his income. He is afraid that his taxes will become $30,600.

    Luckily, that isn’t the case. Progressive tax brackets can make the math a bit cumbersome, but they are designed to give smooth transitions to tax burdens.

    United States Federal Taxes

    In the United States, there are two taxes that most people have to deal with: the Federal Personal Income Tax and Social Security Tax.

    The Social Security Tax is designed to fund Social Security and is actually made up of taxes applied to workers, their employers, and the self-employed. The good news for lottery winners is that lottery winnings are not subject to the Social Security Tax. But the fact that you are not paying into Social Security can have important implications that you should discuss with your financial advisor. Depending on your age and employment history, you may not have contributed enough to Social Security to earn benefits from it. That means you would have to take action to provide your own financial safety net.

    The Federal Personal Income Tax is a straight forward progressive tax. The table below shows the tax brackets for someone who is married and filing their tax return jointly with their spouse. While this gives you an idea of what the taxes associated with a multi-million dollar jackpot would be, there will be factors to discuss with your tax consultant. Your marital status, your current income level, along with any deductions which you might qualify for will all have to be factored into your decisions.

    Federal Personal Income Tax Brackets 2018-2019
    Income Tax Rate
    $0 to $19,050 10%
    $19,051 to $77,400 12%
    $77,401 to $165,000 22%
    $165,001 to $315,000 24%
    $315,001 to $400,000 32%
    $400,001 to $600,000 35%
    $600,001 and up 37%

    State Taxes

    At the state level, tax systems are similar to that of the Federal Personal Income Tax. Individually, they tend to be simpler than the Federal version, but since each state manages its tax system differently, there is immense variation across the country.

    On one end of the spectrum, there are seven states that don’t tax personal income (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) along with two states that only tax investment income and interest (New Hampshire and Tennessee).

    On the other end of the spectrum, some states have multiple tax brackets. For instance, California has 9 tax brackets ranging from 1% on the first $8,544 of taxable income all the way up to 12.3% on $572,981 and above.

    If you are interested in more information, websites such as taxrate.org or https://www.bankrate.com/taxes provide detailed assistance.

    Reciprocal Agreements

    When it comes to state taxes, there is one final point which is important to note. Suppose you are a resident of one state and purchase a lottery ticket in another state. When you win the jackpot, where do you pay taxes? The answer to that question can become very complicated. In some cases, there is a reciprocal agreement in place that helps the states divide up the taxes. But in some other cases, both states will expect to be paid. One because the money was earned in their state and the other because the money was earned by a resident of their state.

    The reason this matters to lottery players is because some residents of states which don’t have lotteries cross state lines to play. This is completely legal, but it can have significant tax implications. It pays to be aware of this detail so that you are not surprised by it later.

    Tax Withholding

    Lottery winnings over $5,000 are subject to a 24% withholding rate (it used to be 25%). Both the winnings and the withholding are reported to the IRS using a Form W-2G.

    This is an important detail to keep in mind on the exciting day that you pick up your giant check. There will be a lot of paperwork and it will look like the taxman is taking a huge bite out of your prize. But notice that 24% is not the top tax bracket that you might have to pay. In fact, 24% is the federal tax rate that applies to earnings under $300,000.

    If you won millions of dollars, there could be a sizable gap between what was withheld and what you owe. Working closely with your financial advisors will be vital to make sure that you don’t get surprised by a significant bill when your taxes are due.

    Other tax considerations

    As we mentioned at the beginning of this article, we have focused on the tax concerns that a new winner would face the year they win their jackpot. But as time goes on, there are many more specialized concerns that will have to be addressed and can only be managed by professionals.

    Some examples of these issues are specialized taxes like California’s 1% tax on income over $1 million for mental health services, property taxes on those nice houses and cars you are going to buy, gift taxes, and inheritance taxes.

    With the help of a knowledgeable team of experts, these issues can be reduced to manageable decisions that any multi-millionaire like you regularly addresses.

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