Winning the lottery can be taxing

By David Katzman

Like most people, you’ve probably idly daydreamed about spending a lottery windfall. If your daydream becomes reality, however, you’ll need to plan carefully because winning the lottery can be taxing.

Lottery winnings are considered gambling profits, which means the Internal Revenue Service (IRS) treats them as ordinary income. Depending on your residency, state and local income tax could also be owed. The good news is you are allowed to deduct any gambling losses against your winnings, but you’ll need to produce documentation and your claimed losses cannot exceed the amount of your winnings each year.
When do you pay taxes on winnings?

Determining when you owe taxes is relatively simple. You owe when you receive your cash or prize. For example, if you receive a lump sum cash prize or win a car this year, all related taxes are owed in 2007. In the case of a non-cash prize, taxes are assessed on the fair-market value of the item. If your prize is paid in annual installments, you owe taxes each year on that year’s installment amount.

If your win is greater than $5,000, some taxes will be automatically withheld. If you provide your Social Security number, 25 percent will be withheld for federal income tax, which will be reflected on Form W-2G. If you owe state and local taxes, there could be additional withholdings. However, if your tax bracket is higher than 25 percent, you may need to pay estimated taxes, which are paid quarterly, in order to avoid a penalty when you file your tax return. A tax professional can help you determine if estimated taxes need to be paid.

Some other considerations

Several other factors could also affect your taxes. If you are sharing your winnings with others, your tax liability will depend on the structure of the agreement—before you won. For example, if you can establish that a group, such as several coworkers, jointly owned a winning lottery ticket then each person, in accordance with their share of the windfall, will owe taxes. If the ticket belonged solely to you but you elected to share after winning, you could be liable for all taxes owed. In addition, any money you shared would be considered a gift, so you could be assessed a separate gift tax.

If you get a divorce or are separated while you are receiving installment payments, you’ll need to exercise particular care. If you and your spouse are splitting future payments, be sure that the agreement specifically addresses who pays the taxes. In some instances, divorce settlements have left one party with the entire tax bill, while the installment payments were divided equally.

If you are receiving annual installments and you die, the determined value of the remaining balance of your prize immediately becomes part of your estate, which could trigger estate taxes. Because your annual prize installments will continue as scheduled, this could leave your heirs with an immediate estate-tax bill that they are unable to pay. For this reason, you should have your estate plan reviewed if you will be receiving prize payments over an extended period.

While there may be a pot of gold at the end of the lottery rainbow, the IRS will also be there. As a result, prudent winners should postpone any buying sprees until they consult a tax professional.

David A. Katzman is a certified public accountant licensed to practice in the State of Florida and the Commonwealth of Massachusetts. He is also a certified financial planner and certified senior advisor. Please consult your tax advisor for details and assistance in applying this general information to your specific situation.