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Is lottery considered gambling for tax purposes?

The question of whether lottery winnings should be considered gambling income for tax purposes is an interesting one that many lottery winners find themselves asking. The short answer is that yes, lottery winnings are generally considered gambling winnings and therefore taxable as ordinary income for federal tax purposes. However, the full answer is more nuanced.

How lottery winnings are taxed federally

At the federal level, the Internal Revenue Service (IRS) considers lottery winnings to be gambling winnings. This means that any winnings from the lottery, including scratch tickets, pull tabs, keno, raffles, daily lottery games like Pick 3 or Pick 4, or big multi-state games like Powerball or Mega Millions, are all considered gambling income.

And just like winnings from other forms of gambling, lottery winnings are fully taxable and should be reported as “other income” on your federal tax return. They are taxed at your ordinary income tax rate, which ranges from 10% to 37%, depending on your tax bracket.

The taxation of lottery winnings does not depend on the size of the prize. Winning a $500 prize carries the same tax treatment as a $500 million jackpot prize. Both are considered gambling income and taxed as ordinary income.

Withholding requirements

When you win more than $5,000 from the lottery, the organization paying out your prize is required to withhold 24% for federal taxes before distributing your winnings. Many states also require state income tax withholding as well, which can be anywhere from 2% to 8% of your prize money.

For very large jackpots, the mandatory withholding only covers a portion of the taxes owed. As a result, lottery winners often owe additional money when they file their tax return for the year they won the prize. Calculating estimated taxes throughout the year can help avoid a big tax bill.

Record-keeping requirements

The IRS requires detailed record-keeping of all gambling winnings and losses. For the lottery, this means keeping your winning tickets, receipts, and records of any taxes withheld when you claimed your prize. If you win small prizes throughout the year, add them up at tax time to determine if you crossed the reportable threshold amount.

Impact on tax refund

Reporting gambling income from the lottery or other sources on your tax return often reduces tax refunds people expect. This happens because taxes were not already withheld from gambling winnings like they are from employment wages. As a result, including significant gambling income without making estimated tax payments can result in owing taxes rather than receiving a desired refund.

State taxes on lottery winnings

In addition to federal taxes, most states also tax lottery prizes won by residents. Only a handful of states with no income tax, like Florida and Texas, do not tax lottery winnings.

States use one of two main methods for taxing lottery winnings:

  • Ordinary income tax method – Lottery prizes are taxed as ordinary income, using the state’s income tax rates and brackets. This is similar to federal treatment.
  • Flat tax method – Lottery winnings are subject to a flat tax rate, often around 4-8% of the prize amount, regardless of the winner’s overall income level.

Some states use a graduated method, applying their income tax rates up to a certain prize amount, then switching to a flat tax beyond that. Many states also require withholding from large lottery prizes.

Winners should be sure to check their own state’s rules to determine what taxes apply to their particular lottery prize.

Are lottery winnings considered earned income?

Lottery winnings are not considered earned income for tax purposes. Earned income refers to wages, salaries, tips, and net earnings from self-employment. It is income received in return for providing labor or services.

In contrast, lottery winnings are considered “unearned” income. They do not derive from work performed but rather from chance gambling winnings.

This distinction matters for certain tax credits and deductions that rely on the amount of a taxpayer’s earned income. For example:

  • The Earned Income Tax Credit – A refundable tax credit for low income workers. Lottery winnings do not qualify for this credit.
  • IRA contributions – IRA contributions can only be made using earned income, not lottery winnings.
  • Child tax credit – The amount of this credit depends on earned income.

So while lottery winnings increase your gross income and tax liability, they do not count as earned income for purposes of tax credits based on employment and self-employment.

Are lottery losses deductible for taxes?

Unfortunately for lottery players, losses from the lottery are not tax deductible. Gambling losses are only deductible if you itemize deductions and keep a detailed record of wagers and losses. Even then, the deduction only applies to the extent of gambling winnings reported.

This means that if you win $500 from the lottery but lose $2,000 on other lottery tickets in the same year, you can only deduct $500 of those losses against your taxable gambling winnings. You cannot use lottery losses to offset other ordinary income.

In practice, most casual lottery players do not keep the kind of detailed contemporaneous records required to properly deduct gambling losses. And due to the standard deduction nearly doubling under the Tax Cuts and Jobs Act, many taxpayers no longer itemize their deductions at all. As a result, lottery losses provide little to no tax benefit for the vast majority of players.

Does withholding cover all taxes on lottery winnings?

The mandatory 24% federal withholding and any state income tax withholding taken out of large lottery prizes does not necessarily cover the full tax liability on those winnings. The withholding is simply a portion of the total taxes owed.

Whether withholding covers the full tax bill or not depends on several factors:

  • The winner’s tax bracket – Those in higher brackets owe a larger percentage of their winnings to taxes.
  • Other income sources – Lottery winnings stack on top of any other earnings.
  • Whether state taxes apply – State taxes can add another significant tax liability.
  • Withholding allowances claimed – More allowances results in less withholding.

It is quite common for big lottery winners to owe additional federal and state taxes when filing their returns. Consulting a tax professional to estimate total tax liability is recommended, especially for large prizes.

Are lottery winnings taxable after death?

Yes, lottery winnings continue to be taxable income even if the winner dies before receiving all payments. If winnings are paid out as an annuity over many years, any remaining payments after the winner’s death must still be reported by their estate or heirs receiving the income.

The taxation of lottery winnings at death depends on a few factors:

  • If the winner elected the cash or annuity option – Lump sum payments are easier to deal with than annuities.
  • The timing of the winner’s death – Earlier death means more remaining payments.
  • Who inherits the winnings – Spouses receive special tax treatment.

Consulting an estate planning attorney can ensure the most tax-efficient handling of lottery winnings after a winner’s death.

Special considerations for jackpot winners

Winning a giant multi-state lottery jackpot brings additional tax considerations beyond regular lottery prizes. Mega Millions and Powerball jackpots often top $500 million, balloon to $1 billion, or more. Winners of prizes this enormous must navigate special tax rules.

The biggest issue is that the 24% federal withholding will not come close to covering taxes owed on hundreds of millions in winnings. The top 37% income tax rate, combined with state income taxes, means over half the advertised jackpot may go towards taxes. Professional tax planning is essential.

Additionally, anonymity becomes difficult. Most states allow lottery winners to remain anonymous, with the lottery claiming the prize on their behalf. But for giant jackpots, rumors spread quickly and winners are often identified. This unwanted publicity brings additional financial concerns.

Wealth management, legal protections, and adjusting to a lavish lifestyle are just some of the challenges faced by those lucky few who beat the impossible odds and win a massive lottery prize.

Can you establish a trust to claim lottery winnings?

Yes, it is possible to have a trust rather than an individual claim a lottery prize. This keeps the winner’s identity anonymous and may provide estate planning benefits as well.

There are two main options for claiming lottery prizes with a trust:

  • Blind trust – The lottery winner establishes the trust, but the trustee is the only one who knows the winner’s identity. This keeps privacy while still providing a layer of asset protection.
  • Nominee trust – Attorney or other third party establishes trust on winner’s behalf without disclosing their identity. Provides the most anonymity but less control for the winner.

The requirements and rules for trusts claiming lottery prizes vary by state. Consult an experienced attorney to properly establish a lottery trust in your jurisdiction.

Lottery winnings and gift/estate taxes

Lottery winners sometimes use their newfound wealth to make large gifts to family and friends. But gifts in excess of the annual exclusion amount ($16,000 for 2023) may trigger federal gift and estate taxes.

If total taxable gifts exceed lifetime exemptions ($12.92 million for 2023), gift taxes of up to 40% apply. Additionally, estate taxes up to 40% apply when a lottery winner dies if their assets exceed exemption amounts ($12.92 million for 2023).

Estate planning strategies like gift-splitting with a spouse and hiding assets in irrevocable trusts can reduce exposure to gift and estate taxes. Consulting a tax attorney or estate planner is wise for big lottery winners making large gifts.

Are lottery winnings considered capital gains?

No, lottery winnings do not qualify for the preferential tax rates applied to long-term capital gains. Capital gain tax rates, which range from 0% to 20%, only apply to appreciation of capital assets like stocks or real estate.

Lottery winnings are ordinary gambling income, even if paid out over many years. As ordinary income, lottery prizes remain subject to individual income tax rates which currently range up to 37%. Lottery winnings are not eligible for lower capital gains rates.

However, if a lottery winner subsequently invests their winnings and earns interest, dividends, or capital gains, those would be taxed at applicable capital gains rates. Only the original lottery prize is ordinary income.

Reducing taxes on lottery winnings

There are some steps lottery winners can take to potentially reduce the taxes owed on their gambling windfall:

  • Move to a state with no income tax like Florida or Texas
  • Contribute winnings to a retirement plan if allowed
  • Offset winnings by realizing capital losses
  • Donate a portion of winnings to charity
  • Purchase tax-advantaged investments like municipal bonds

However, there is no way to completely avoid taxes on lottery winnings apart from not claiming the prize at all. Taxes on gambling winnings are unavoidable.

Income limits on lottery winners

Large lottery winnings can sometimes impact eligibility for programs and benefits that have income limits. Examples include:

  • Medicaid – Eligibility thresholds vary by state but are typically under $20,000 for seniors.
  • Supplemental Security Income – Federal benefits limit of $861 per month for individuals in 2023.
  • Affordable Care Act subsidies – Income limits between 2-4 times the federal poverty level.
  • Food stamps – Gross monthly income typically must be under 130% of poverty.

Lottery winners who become instantly “wealthy” may lose access to some assistance programs they previously qualified for. Each program has different rules so it is important to check how specific benefits you receive will be impacted by lottery winnings.

Verifying lottery winnings for lenders

Banks and lenders will usually want verification of any significant lottery winnings before relying on that income for loan qualification purposes. Typical documentation includes:

  • A copy of the winning lottery ticket or claim form
  • A verification letter from the lottery commission
  • Bank statements showing deposit of winnings
  • The winner’s IRS Form W-2G showing amount won

Providing documentation helps substantiate that the borrower has receive the winnings and has the funds available to make loan payments or as a down payment. Lawfully earned gambling winnings can absolutely be used as income when applying for loans or mortgages if properly documented.

Lottery winnings and taxes – The bottom line

While winning the lottery may seem like a magical tax-free windfall, the reality is that winnings from lotteries and other forms of gambling are fully taxable. Federal and state income taxes combined can take a substantial bite out of prize money.

Careful planning with a tax professional can help maximize what a lottery winner gets to keep while staying compliant with all tax laws and regulations. But there is no escaping the tax man when you strike it rich with a big lottery payday.