Winning the lottery is an exciting event that most people only dream about. But if you are lucky enough to win a large lottery prize, you may be wondering about the tax implications. Specifically, you may be asking: does the IRS tax lottery winnings twice?
The Short Answer
The short answer is no, the IRS does not tax lottery winnings twice. However, lottery winnings are taxed both at the state and federal level, which can feel like double taxation. Here’s how it works:
- State taxes: Most states tax lottery winnings at the state income tax rate. This tax is withheld upfront when you claim your prize.
- Federal taxes: Lottery winnings are also subject to federal income taxes. You must report winnings on your federal tax return and may owe additional taxes, depending on your overall income and deductions for the year.
So while lottery winnings are taxed at both the state and federal level, they are not taxed twice by the same governing body. The withholding amounts are meant to cover your estimated state tax obligation. But you may still owe additional federal tax when you file your return for the year.
State Taxation of Lottery Winnings
Most states tax lottery winnings in the same way they tax other income. This means lottery winnings are subject to the state’s income tax rates.
Here are some key facts about state taxation of lottery winnings:
- Withholding: Most states require upfront withholding on lottery winnings to cover the applicable state income taxes. Withholding amounts vary by state but are often in the range of 4-8% of the prize amount.
- Tax rates: Lottery winnings are taxed at the winner’s ordinary state income tax rate. Rates range from 0% in states with no income tax up to 13.3% in the highest tax bracket in California.
- Reporting: Some states require you to complete a state-specific tax form to report lottery winnings. In other states, you just report the winnings on your regular state tax return.
- Non-resident taxation: If you win the lottery in a state you don’t live in, you may owe taxes in both your home state and the state where you purchased the ticket.
So at the state level, lottery winnings are subject to income tax withholding upfront, when you claim the prize. The amount withheld is meant to cover your estimated state tax obligation from the winnings.
State Tax Withholding Examples
To see how state tax withholding on lottery winnings works, consider these examples:
- California: You win $1 million in the California lottery. California requires 8% withholding on lottery winnings for state income taxes. So $80,000 would be withheld upfront, leaving you with a prize of $920,000.
- Florida: You win $500,000 in the Florida lottery. Florida has no state income tax, so no state tax would be withheld.
- New York: You win $5 million in the New York lottery. New York requires 8.82% withholding on lottery winnings. So $441,000 would be withheld upfront for state income taxes.
Federal Taxation of Lottery Winnings
At the federal level, lottery winnings are taxed like ordinary income. Here are some key points on federal taxes and lottery winnings:
- Reporting: You must report all lottery winnings on your federal income tax return. Winnings are reported on Form 1040 as “Other Income.”
- Withholding: Federal tax is not withheld directly from lottery winnings. But you can request voluntary withholding.
- Tax rates: Lottery winnings are taxed at your federal income tax rate—from 10% to 37% depending on your overall income and filing status.
- Self-employment tax: Federal self-employment tax of 15.3% may apply if you are in the business of gambling. This rarely applies to individual lottery players.
So at the federal level, lottery winnings increase your overall income for the year. Depending on your specific situation, this may push you into a higher tax bracket.
You also miss out on the benefit of wage withholding that applies to normal paychecks. As a result, you may owe substantial federal taxes when you file your return for the year of the lottery win.
Federal Tax Examples on Lottery Winnings
To illustrate, suppose you win a $1 million lottery prize and have $50,000 in ordinary income from your job. Here is how federal taxes would apply:
- You collect $1 million in lottery winnings with no federal tax withheld.
- You have taxable income of $1,050,000 for the year including wages and winnings.
- The first $9,950 is taxed at 10%, the next $30,575 at 12%, and so on through the tax brackets.
- Your total federal tax bill would be around $342,000.
- You would owe this full amount when filing your return since no tax was withheld from the lottery winnings.
The higher your ordinary income, the higher your federal tax rate applies to the lottery winnings. Withholding is advisable if you anticipate owing substantial taxes on the winnings.
Tax Considerations for Large Jackpots
Mega Millions and Powerball jackpots can climb into the hundreds of millions of dollars. Winnings on this scale bring additional planning considerations:
- Withholding: You may want to opt for much higher voluntary federal withholding to cover the enormous tax bill.
- Tax bracket: A jackpot this size could easily propel you into the 37% maximum federal tax bracket.
- AMT: You may be subject to the Alternative Minimum Tax (AMT), which removes many deductions.
- Reduce taxes: Strategies like charitable donations and forming a trust could potentially reduce your tax bill.
- Professional help: Financial and legal advice is critical before claiming a large lottery prize.
The bottom line is that large lottery jackpots come with enormous tax obligations. Proper planning is essential to maximize your lottery winnings after taxes.
Can You Avoid Taxes on Lottery Winnings?
Given the substantial taxes on lottery winnings, you may wonder if there are any ways to avoid paying taxes on a lottery prize:
- Remain anonymous: A few states allow you to claim winnings anonymously or via a trust. This avoids public records, but does not reduce legal tax obligations.
- Leave the country: You could theoretically move to a country with no income taxes like the United Arab Emirates. But the U.S. may still tax citizens abroad.
- Donate to charity: If you donate the entire amount to charity, you can avoid income tax. But this forfeits the entire jackpot.
- Buy tax-free bonds: Investing the winnings in certain bonds may allow you to avoid some taxes. But taxes still apply to the initial winnings.
There is no legal way to completely avoid income taxes on lottery winnings. Your best option is to plan ahead and use strategies to minimize taxes as much as possible.
The Tax Bill on Annuity Prizes
Many lottery prizes are issued in the form of annuity payments over a period of 20 or 30 years. For large prizes, the annual payment can be millions of dollars per year.
How does tax withholding work on the annuity payments?
- The full amount of the prize is taxable income in the year the prize is won, even if it will be paid out over decades.
- Taxes for federal and state income tax are withheld from each annuity check before you receive it.
- The withholding amount is typically calculated as if that payment were your only income source for the year.
- You will likely owe additional federal taxes when filing your return, especially in the first year when the full prize amount is counted as income.
In summary, taxes are withheld from each annuity check, but may not cover your full tax obligation across all winnings for the year.
Example: Taxes on a $10 Million Annuity Prize
Say you win a $10 million lottery prize paid as a 30-year annuity. Here is how federal and state taxes might work:
- Full $10 million counts as income in the first tax year.
- $333,333 pre-tax annual annuity payment for 30 years.
- 5% state tax withheld from each payment, or about $16,667.
- 22% federal tax withheld from each payment, or about $73,333.
- Additional federal tax likely owed when filing for the year.
In this example, over $90,000 in taxes are withheld from each annuity payment. But the winner likely owes far more for the year based on the full $10 million prize.
strategies to reduce taxes on Big in winnings After
Winning millions of dollars in the lottery is incredibly exciting. But before you spend the money, be sure to come up with a tax strategy to maximize your winnings. Here are some ways to potentially reduce taxes on a big lottery prize:
Claim winnings strategically
Consider the timing of when you claim the prize. Claiming winnings in January results in nearly a full year of interest before taxes are due in April. Conversely, claiming a prize right before the tax-filing deadline gives you less time accruing interest – meaning less taxes owed. Also weigh lump sum versus annuity: Lump sum allows more flexibility for tax planning but results in a larger first year tax hit.
Contribute to retirement accounts
Use your lottery winnings to maximize contributions to tax-advantaged retirement accounts like 401(k)s and IRAs. This reduces your taxable income for the year. Just beware contribution limits and eligibility restrictions based on income.
Invest in municipal bonds
Interest earned on most municipal bonds is exempt from federal taxes. Buying muni bonds with a portion of the winnings can provide tax-free investment income.
Donate to charity
If philanthropy is part of your lottery plans, donate a portion of the winnings to charity. This creates a tax deduction to help offset the taxes you’ll pay on the winnings. Just be sure to itemize deductions on your return.
Pay down debts
Using a fraction of the prize to pay down debts – like credit cards, student loans and mortgages – reduces taxable income derived from that debt and interest payments going forward.
Invest in real estate
Real estate rentals can offer great tax advantages like depreciation deductions on properties. Just be aware of passive activity loss rules limiting write-offs against other income like lottery winnings.
Establish a trust
A trust allows you to transfer assets and potentially shift some tax burden from yourself to the trust. This requires careful set-up and maintenance to preserve benefits.
The bottom line is proper tax planning is crucial to minimize what goes to the government and maximize what goes in your pocket from a big lottery win. Consult closely with financial and legal advisors to employ the best strategies given your specific situation.
Frequently Asked Questions
Does federal tax apply if I live in a state with no income tax?
Yes, federal income tax still applies no matter where you live in the U.S. The state you reside in determines if you also owe state tax on the winnings. But all U.S. residents owe federal taxes on lottery winnings.
Can I avoid taxes by putting the lottery ticket in a family member’s name?
No, taxes legally apply to the person who purchased the ticket and actually won the prize. The IRS will expect taxes to be paid by the true winner.
Are lottery winnings taxed like ordinary wages?
Not exactly. Lottery winnings are taxed like ordinary income, but have no wage withholding. Taxes on wages are spread out over the year, while lottery taxes are typically paid in one lump sum when filing the return for the winning year.
Do I still owe taxes on lottery winnings after leaving my job?
Yes, you are still responsible for applicable federal and state income taxes on lottery winnings even if you are retired or otherwise have no ordinary income from wages. The lottery winnings themselves are fully taxable.
Can I deduct gambling losses against lottery winnings?
Yes, you can deduct gambling losses to the extent of gambling winnings. So if you lost $5,000 on lottery tickets and separately won $10,000, you could deduct the $5,000 loss against the winnings on your tax return.
Conclusion
Winning the lottery certainly comes with life-changing sums of money. But it also comes with substantial taxes – at both the state and federal levels. Although lottery winnings are not taxed twice per se, you will likely owe both state income taxes and federal income taxes on prizes. Proper planning is key to maximizing your winnings and mitigating taxes. Be sure to consult tax professionals to employ the best strategies for your specific situation. While the IRS will take a piece of your prize, a bit of planning can help you hold onto more of your hard-earned lottery jackpot.
