Taxes on Lottery Winnings Explained
It’s a quip you hear often when the lottery jackpot creeps upward: “Sure the jackpot is $40 million, but what do they leave you after taxes?” Honestly, on a jackpot this high, the answer is more than enough. But the exact amount depends on several factors, including your tax bracket. Before you start daydreaming about what you would do with your prize money, here’s a primer on how much you might actually get.
How Are Lottery Winnings Taxed?
The IRS will charge you federal tax on the net amount of your lottery winnings. The net amount is the total of your winnings minus the cost of the lottery ticket, which usually isn’t more than a few dollars. After calculating your net winnings, the first thing the IRS will do is take 25 percent of your prize money for taxes. This 25 percent is withheld from your winnings, so you won’t ever actually get this money. It will go directly to the IRS instead.
Your tax obligation is not yet fulfilled, however. Lottery prizes get taxed under the same rules as regular income tax. Whatever prize money you receive during the year is added to your taxable income when you file your tax return. You are then taxed at the appropriate rate based on your income tax bracket. It’s not quite that straightforward, however…
Federal Income Tax Bracket
It is very possible – and quite likely – that your lottery money will bump you into a higher tax bracket. This makes it important to understand how tax brackets work. The highest tax bracket is 37 percent. But if you’re in this bracket, it doesn’t mean that you pay a tax rate of 37 percent on all of your income. This is because the tax is progressive.
Here is what that means. Let’s say that the lowest tax bracket (10 percent) is for people who make $0 to $10,000 per year. (Please note that it is not. We are using made-up numbers for the sake of simplicity here — you can find information on the actual brackets at IRS.gov.) You make $15,000, which bumps you into the next bracket (12 percent). You would pay a tax of 10 percent on your first $10,000 and 12 percent on the remaining $5,000.
Your total tax bill would break down as follows:
($10,000)(10%) = $1,000
Assuming no deductions or other complications, your tax bill would be $1,600.
Lottery winnings work the same way. The amount you received during the tax year (not the amount you won)is added to your annual income and taxed accordingly based on your new tax bracket. It may seem complicated, but this type of taxation actually works to your benefit. If the tax wasn’t progressive, your tax liability would be($15,000)(12%), which is $1,800. In this example, the progressive approach saves you $200. As your income goes up, so does the amount a progressive system saves you.
What about State Taxes?
Paying federal taxes on your lottery prize doesn’t necessarily mean you’re done. You may have to pay state tax, too. The tax rates and rules for lottery winnings vary from one state to the next, so you need to check with a CPA or local taxing authorities to learn how your state handles taxing lottery payments. Generally, however, state tax rates vary from 2.9 to 8.8 percent.
As of 2022, there are nine states that don’t levy a state income tax. They are Alaska, Florida, Nevada, New Hampshire, South Dakota Tennessee, Texas, Washington, and Wyoming. These states won’t tax your lottery winnings.
If you traveled out of state to buy your lottery ticket, you need to understand that things get a little more complicated. The state where the lottery ticket was sold will usually withhold taxes from lottery winnings. Let’s say you live in South Dakota where there is no state income tax. You go visit your brother in North Dakota and buy a lottery ticket while you are there. You win. You may have to file a state tax return in North Dakota to get a refund of any prie money North Dakota withheld for state income tax.
A similar scenario may occur even if you live in a state that does charge income tax. Let’s pretend you live in Ohio, where the tax rate is 3.99 percent. You buy a lottery ticket in Pennsylvania, where the tax rate is 3.7 percent, and you win. Pennsylvania withholds 3.7 percent from your lottery payment. You will have to file your personal income tax return in Ohio as you normally would and claim your lottery winnings. You would get credit for the taxes you already paid to Pennsylvania, but you may still owe more since Ohio’s tax rate is higher than Pennsylvania’s.
The revere is also true. If you live in a state that charges a lower income tax than the state in which you win the lottery, you could pay too much tax. You may have to file a return to get a refund if too much money was withheld. If you live in Pennsylvania but win in Ohio, you may need money back since Ohio charges a higher income tax than your home state of Pennsylvania.
Is There a Difference for Lump Sum or Annuity Payments?
Is there a difference in the taxation of lump sum payments versus annuity payments? Yes and no. Technically, the answer is no. The IRS taxes the money in the exact same manner, whether you take a lump sum payment or not. Twenty-five percent comes off the top of your winnings, and then you pay tax on the amount you receive during the tax year based on your bracket.
Even though the tax calculation method is the same, the amount of money you owe at tax time will look dramatically different from one option to the next. A lump sum payment means you will get taxed on all of your winnings at once in a single tax year. This can result in a hefty tax bill. You can lower your tax bill each year by spreading out the payments you receive.
Don’t let this discourage you from taking a lump sum payment, however. If you want to purchase a large ticket item or have a financial advisor who can wisely invest your winnings, a lump sum payment may be the best option for you. This is something you and your accountant or financial advisor need to discuss.
How to Lower The Taxes Owed After You Win the Lottery
The simple fact is, if you win the lottery, the tax man is coming. But that doesn’t mean you can’t devise some legal strategies for reducing what you owe him. Depending on how much you win, taking an annuity payment each year can keep you in a lower tax bracket and reduce your tax rate.
You can also reduce your tax liability by making significant charitable donations. Depending on the amount you win, you can make sizable tax-deductible donations and still have plenty of cash left for yourself.
Plan on helping family and friends now that your flush? Be smart about how you help. Cash gifts under $15,000 won’t trigger the gift tax. Neither will gift paid directly to medical facilities or colleges and universities. You could pay off your mother’s medical debt or put your best friend through college without paying a gift tax on the money if you pay the respective institutions directly.
What to Do After Winning the Lottery
If you have a trusted CPA or financial advisor, the very first thing you need to do after winning the lottery is call them. Now. If you don’t already have a CPA, find one. Don’t be one of the many people who make the mistake of mishandling their lottery winnings and then losing all of their money. If you win enough, a lottery jackpot can be a life-changing event. Make sure you handle yourself well so you can enjoy the good life rather than wondering where it all went wrong.
Once you have the preliminary details worked out, it’s also a good idea to see an attorney. She can help you with estate planning and advise you on any legal issues that may arise. Sometimes friends and family start to come out of the woodwork after someone wins the lottery, often trying to make a play for some of the cash. A lawyer can help you protect yourself in the unfortunate event that you need to.
Again, we can not stress enough the importance of seeking out a CPA for sound financial advice after winning the lottery. Many, many things about your life, financial situation, and tax picture are about to change. The sooner you reach out to us, the sooner we can start preparing you for all the things that come next. We want to help you minimize your tax liability and secure your financial future so you really can buy that private island or follow your other lottery dreams.