American investors have plenty of ways to make the most of their cash, but a surprising amount of people puts their faith in the lottery. Research shows that 21 percent of people in America believe that the lottery is the most practical strategy they have for accumulating wealth, so it's unsurprising that so many consumers continue to buy their draw tickets. If you are lucky enough to win the lottery, your first thought may turn to how you plan to spend your winnings, but you should really first understand the tax implications of your new windfall. Learn more about how the tax law affects lottery winnings, and how you can lower the amount of cash the IRS takes from you.
Tax liability on lottery winnings
In the United States, the IRS sees all gambling winnings as fully taxable income. This definition applies to winnings from lotteries, raffles, sports bets and casino games. You should also know that the IRS applies the same definition to non-cash prizes, including cars, homes and holidays, and will use the fair market value of these winnings to calculate tax liability.
As such, you must declare any lottery winnings on your annual tax return. In some cases, the payer may deduct the tax at source, in which case you should receive a W-2G form that explains how much tax the company has taken. On the upside, you can also deduct gambling losses from your return, but you cannot include a value that is higher than any winnings.
Amount of tax payable
Tax laws change all the time, so you should always talk to a tax professional to confirm how much tax you owe on lottery winnings. That aside, a large lottery prize will almost certainly attract the top rate of federal income tax.
In many states, winners also become liable for a state income tax. For example, people living in New York have one of the highest state income taxes. As well as a top rate of state income tax, city residents also have to pay a levy on income over a certain amount. As such, a New York City resident could up losing as much as 48.5 percent of his or her lottery winnings to tax.
Other forms of tax
The IRS may also take more tax if you share your earnings, but you can lower your liability by giving away your cash carefully. Estate tax laws allow you to give money to other people (except your spouse) without paying federal gift tax, but the amount is subject to a limit. Winners can also make certain tax-free gift payments each year. Some states also impose inheritance and estate taxes, so it's often worth giving your winnings away while you are still alive.
Some people believe that they can change their tax liability by moving to a different state. This approach doesn't always work. In many states, tax laws apply to all income that you earned when you were a resident. If you move to another state, you may still have to pay tax on your winnings.
Choosing how to take your winnings
In most cases, lottery winners can choose to take their winnings as a lump sum payment, or as a series of annual payments. Each option has pros and cons. A lump sum payment allows people to make an immediate, significant lifestyle change, but can increase your tax liability. An annual payment guarantees long-term stability, but doesn't normally allow people to make a large immediate investment.
A lump sum payment is likely to attract more tax because you pay your full liability in one go. With an annuity, the amount you receive often increases each year to account for inflation. Although you will continue to pay the top tax rate each year, the total lump sum you receive over the term is normally higher. If the tax rates change in your favor in future years, the total sum you receive is likely to improve even further (although it could work the other way, too).
For many people, the decision ultimately boils down to an individual appetite for risk. If you spend the lump sum payment straight away, you will probably take home considerably less than the total of your annuity payments, but a return of at least 4 percent each year on an invested lump sum could help you outperform an annuity. As such, you should talk to a financial advisor to understand other options that are available to you.
A large lottery prize could change your life, but it's important to understand the implications of this income. Treat your lottery winnings like any other form of investment, and consult a tax professional or investment advisor at places like My Lump Sum to make sure you get the best return on your cash.