Many people play the lottery each week hoping to win big. State lotteries usually pay out in the millions while multi-state power ball lottery wins can pay out over $100 million to the lucky winner. Most lotteries allow the winner to choose between yearly payments or a lump sum payment upon winning. Before deciding which route to go – if you are lucky enough to win – consider the tax consequences.
Consider also: Tax Return Preparation: Tax Services, Tax Help & More
Reporting and Withholding Requirements
The Internal Revenue Service requires anyone conducting a lottery to adhere to a number of reporting and withholding requirements. Lottery winnings over $600 that are at least 300 times more than the original wager must be reported on IRS Form W-2G. This means that the IRS will know how much you won.
Lottery winnings are considered taxable income for federal tax purposes.
In addition, federal withholding taxes must be subtracted from the winnings if the total amount won, minus the amount wagered, is more than $5,000. The lottery agency withholds this sum automatically before handing over your lottery check. The amount withheld will be 25 percent in 2021.
The problem with mandatory withholding is that it potentially leaves a gap between the amount withheld and the amount of tax you owe on the lottery win, if you are in one of the higher tax brackets.
Federal Taxes on Lottery Wins
Lottery winnings are considered taxable income for federal tax purposes. You receive an IRS Form W-2G at the end of the year which will indicate how much you won. The amount must be reported on line 8 – other income – on your Form 1040. The amount of taxes you actually pay on the winnings will depend on the amount you won, your filing status and a variety of other factors.
Consider also: Form 1040: What You Need to Know
State Taxes on Lottery Wins
Lottery winnings are also considered taxable income for state tax purposes. If you live in a state that requires you to file, and pay, state income taxes, then you will be taxed on your winnings. Whether or not you must pay state taxes on the winnings depends on your state of residency. Some states, such as Florida for example, do not require residents to pay state income tax; however, states that do collect income tax can run as high as 8.82 percent.
Beware the Tax Gap
If you are lucky enough to win a sizable lottery jackpot, and elect to accept the lump-sum payout, consult with a tax professional as soon as possible. Although the federal government requires withholding of a percentage of your winnings, you may actually owe more than the amount withheld.
A lump-sum lottery payout can easily put you into the highest tax bracket, which, as of the date of publication, applies to income over $523,600. At the highest tax bracket, you will owe 37 percent in federal taxes which is significantly more than the 25 percent withheld. In addition, state taxes may not have been withheld at all, but still must be paid on your lump-sum winnings.