Winning the lottery can have a significant impact on your tax return. When you win a large lottery prize, you will need to pay taxes on your winnings. The amount of tax you owe will depend on several factors, including the size of your prize, whether it is paid out as a lump sum or annuity, and the tax laws in your state. While winning the lottery may seem like all upside, it is important to understand how it will affect your taxes so you can be prepared when tax time comes.
Do you have to pay taxes on lottery winnings?
Yes, lottery winnings are considered taxable income under federal and state tax laws. If you win $600 or more from the lottery, the lottery organization is required to report your winnings to the IRS and state tax authorities using a Form W-2G. Any amount you win, no matter how small, counts as taxable income and must be reported on your tax return.
When you file your tax return for the year you won the lottery, you will need to include the full amount of your winnings on your federal tax return even if you haven’t received all the money yet. For example, if you win a $1 million prize paid out in 20 annual installments, you would report the full $1 million as income on your tax return for the year you won, regardless of how much money you actually received that year.
How much tax is owed on lottery winnings?
Lottery winnings are taxed at the highest federal tax rate, which is currently 37% for any earnings above $539,900 (for 2023 taxes). State income tax rates also apply, which range from 0% to over 13%, depending on the state. Some examples:
- If you win $100,000 in the lottery, you would owe approximately $26,000 in federal taxes (assuming the highest tax bracket) and $6,500 in California state taxes (at a 6.5% rate).
- On a $1 million lottery prize, you would owe around $370,000 in federal taxes and $130,000 in California state taxes.
- For a $10 million jackpot, federal taxes would be $3.7 million, plus another $1.3 million in California taxes.
The tax rates on lottery winnings are typically much higher than regular income tax rates. However, you may be able to offset some of the taxes with gambling losses claimed as itemized deductions on Schedule A of your federal return. You cannot reduce lottery winnings by the cost of your lottery tickets.
Does withholding apply to lottery winnings?
Yes, federal and possibly state taxes are withheld immediately from lottery winnings over certain thresholds. Withholding ensures that a portion of the taxes are paid upfront and you don’t owe the full amount when you file your tax return.
For lottery prizes over $5,000, 24% federal tax is withheld. State taxes may also be withheld, depending on where you purchased the winning ticket. You may have taxes withheld at a higher rate by filling out paperwork with the lottery commission that awards your prize.
At tax time, the amount withheld is applied to your total tax liability. You will need to pay any remaining taxes you still owe after accounting for the withholding when you file your tax return.
Are lottery winnings considered earned or unearned income?
Lottery winnings are considered “unearned income” rather than wages or self-employment income. This distinction is important because unearned income is not eligible for certain tax benefits.
For example, you cannot contribute lottery earnings to a Traditional IRA or 401(k). Lottery winnings also do not qualify for the Earned Income Tax Credit which benefits lower-income working individuals. On the plus side, unearned income from lottery winnings is not subject to payroll taxes or self-employment taxes.
How does winning the lottery affect your tax rate?
Winning a large lottery prize can potentially push you into a higher federal income tax bracket. Tax rates are tiered based on income levels, and go up as your income increases. The current 2023 federal tax rates are:
- 10% for income between $0 to $11,000 (single filers)
- 12% for income between $11,001 to $44,725
- 22% for income between $44,726 to $95,375
- 24% for income between $95,376 to $182,100
- 32% for income between $182,101 to $578,125
- 35% for income between $578,126 to $693,750
- 37% for income above $693,751
For example, if you were previously in the 22% bracket, winning millions of dollars could push part of your income into the top 37% bracket. This is important to factor in when considering required tax withholding or estimated payments.
Do state taxes apply to lottery winnings?
Yes, your state of residence will tax your lottery winnings in addition to federal taxes. If you purchased the winning ticket in a different state from your state of residence, that state may also tax a portion of your winnings.
State income tax rates range from 0% to over 13%. Some states, like California, New Jersey, and New York have top rates over 10%. Make sure to understand your state’s tax rates to estimate how much you will owe.
A few states that do not have income tax, like Florida, Texas, and Washington, will still tax lottery winnings of residents. Non-residents will not owe state tax in those states. Check with a local tax professional to understand state tax obligations.
What if you win the lottery as part of a group?
If you win the lottery as part of a group, such as an office pool, the tax implications can become more complicated. The first step is figuring out ownership of the winning ticket. If one person in the group holds the ticket in their name and signs it, then they are considered the winner for tax purposes.
If the ticket is signed by multiple people or held in a group name, you will need to determine how the prize is allocated among group members. Typically this is done based on contributions to purchasing tickets. So if you contributed 10% to buy the winning ticket, you would allocate 10% of the prize money and associated taxes to yourself.
Make sure there is clear documentation on how the prize is being divided to avoid discrepancies when income and taxes are reported. Consider forming a legal entity like a partnership to formalize the agreement and allow for a simple distribution of funds.
How are taxes handled if you take annuity payments?
For large lottery jackpots, you are sometimes given the choice between receiving your full winnings in a lump sum or in annuity payments spread over many years. If you choose the annuity payments, your taxes are handled a little differently.
Rather than owing taxes on the full amount in the year you win, taxes are assessed annually on each payment. The lottery administrator will withhold taxes before distributing your payments to you. So if you win $10 million over 20 years, you may receive around $450,000 each year after taxes are withheld.
Make sure to consider whether the withholding on your payments will cover your full tax liability each year. You may need to make additional estimated tax payments to avoid penalties.
How do you calculate taxes owed on lottery winnings?
Figuring out the full amount of taxes owed on a lottery prize can be tricky. Here are the basic steps:
- Document your total lottery winnings for the year from all sources, including any withholding already paid to state and federal tax authorities.
- Determine your federal and state income tax brackets based on your regular income plus your net lottery winnings.
- Calculate federal tax using the tax tables based on your total taxable income and filing status. Factor in any other income, deductions and credits as usual.
- Do the same calculation to determine state income tax owed.
- Subtract any federal and state tax withholding you already paid to determine the net amount still owed.
This complex calculation is best handled with tax preparation software or by working with an accountant. Make sure to make quarterly estimated payments if needed to avoid penalties.
Are there ways to reduce taxes on lottery winnings?
There are a few ways you may be able to reduce the taxes owed on lottery winnings:
- Offset winnings with gambling losses – You can deduct gambling losses to the extent of gambling winnings as an itemized deduction.
- Contribute to retirement accounts – Up to $6,000 can be deposited into an IRA or Roth IRA to qualify for a tax deduction.
- Donate to charity – If you itemize, charitable contributions are tax deductible.
- Invest in municipal bonds – Interest income is usually exempt from federal (and sometimes state) taxes.
- Claim dependents – Having additional dependents can lower your taxable income.
However, most lotto winners will not find full relief from taxes owed. It is important to set aside a significant portion of your winnings to pay estimated taxes and plan for tax liabilities.
Taxable Income | Tax Rate |
---|---|
$0 to $11,000 | 10% |
$11,001 to $44,725 | 12% |
$44,726 to $95,375 | 22% |
$95,376 to $182,100 | 24% |
$182,101 to $578,125 | 32% |
$578,126 to $693,750 | 35% |
Over $693,751 | 37% |
Should you create a trust to manage lottery winnings?
For large lottery prizes, it can be wise to create a trust to help manage the winnings. A trust allows you to distribute funds to beneficiaries of your choosing while setting conditions around how the money can be used.
A properly structured trust can offer several benefits:
- Avoids publicity and protects privacy
- Allows centralized management of investments
- Lets you control distribution of assets over time
- Provides protection from creditors and lawsuits
- Helps minimize estate taxes when assets transfer to heirs
Setting up a trust takes legal expertise, so it’s important to work with an experienced estate planning attorney if you go this route.
How can you lower your taxable income from lottery winnings?
There are a few strategies lottery winners can use to potentially lower their taxable income from winnings:
- Elect to take annuity payments rather than a lump sum – You can spread payments (and tax liability) over several years
- Invest in tax-exempt bonds – Municipal bond interest is usually exempt from federal tax
- Make charitable donations from lottery winnings – Contributions to 501(c)(3) charities can be deducted
- Contribute to pre-tax retirement accounts like a 401(k) or Traditional IRA – Reduces current taxable income
- Claim dependents – Having dependents can lower your taxable income
- Offset winnings with other deductible expenses like mortgage interest
However, it is unlikely most lottery winners will escape significant tax obligations. Planning ahead, making estimated payments, and working with a tax professional are essential steps.
Conclusion
Winning the lottery certainly has life-changing financial implications. But it also significantly impacts your taxes. Large prizes can push you into the highest tax brackets, meaning you may owe over half your winnings to federal and state authorities. It is critical to plan ahead and work with tax professionals to navigate reporting obligations and minimize what you owe in taxes through available deductions and optimal withholding. While no one wants to dwell on the downsides of winning big, a little tax planning can help you hang on to more of your sudden windfall.