Many lotteries offer the winner the option to take payments over a set period of years rather than a lump sum in the current period. Payments due to the winner after her death must still be paid out based on estate law.
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Individual states set their own lottery rules. In states that offer a lump sum payment, the payment is less than the total amount of the winnings as it represents the present value of future payments. For example, if you win a lottery prize of $1,000,000, you may be offered an annual payment of $50,000 for 20 years or a lump sum payment of $785,000. If the winner chooses annual payments, an issue arises when the winner dies. The winner still has the right to those payments, but they will be received by beneficiaries, depending on the decedent's will and beneficiary provisions.
Estate Tax Issues
When a lottery winner dies before he has received all of his payments from the lottery, the payments become an asset in his estate. Most lotteries set up this way allow for the winner to directly designate a beneficiary. This allows payments to start going directly to the beneficiary. If there is no beneficiary listed on the lottery agreement, the payments go to the winner's estate and will be assigned to a beneficiary based on the will and probate court proceedings. Regardless of whether a beneficiary was named on the lottery agreement, the remaining payments must be valued for estate tax purposes, as the estate may be required to file an estate tax return. The IRS contends the right to receive future lottery winnings should be valued at the present value of an annuity.
Once the stream of lottery payments begins to be paid to the beneficiary, she is responsible for the tax on the winnings. The IRS stipulates that all gambling and lottery winnings are taxable. The beneficiary must report them on her 1040 return in the year the payments are received. Depending on the size of the payments, the lottery corporation may withhold tax and remit only the net amount to the beneficiary. In this case, the taxpayer can claim any withheld tax against the tax owing.
Having a right to receive future lottery payments can also cause problems if you are divorcing. State laws differ on how property is handled in a divorce, but if the lottery prize is divided between spouses, but not legally divided, you may end up paying income tax on 100 percent of the payments rather than just your half. Also, when planning for your death, the tax consequences should be examined by an estate lawyer or experienced CPA to ensure the estate will have enough cash to pay any estate or income taxes owing.