As more and more states — including South Dakota — legalize sports betting, it’s a good time to look at how lottery winnings are taxed. There are also some important non-tax considerations you should consider if you win big … or even not so big.
Q. How are lottery winnings taxed?
A. Lottery winnings are taxable for cash winnings and for the fair-market value of non-cash prizes, like a car or a vacation. Depending on your other income and the amount of your winnings, your federal tax rate may be as high as 37%. Your lottery winnings may also be subject to state income tax.
So, depending on where you live, your total tax bill could be as high as 50%, possibly more. You don’t get any capital gains rate break for lottery winnings, and there isn’t any income averaging to help lower your tax bill.
On the other hand, you’re entitled to a tax deduction for any gambling losses you incurred. These are taken as an itemized deduction, but they can’t exceed your winnings.
If your lottery winnings are payable in annual installments, the installments you get in future years are still gambling winnings. That means any gambling losses in those future years are deductible to the extent of the installments, even if you have no other gambling winnings in those years.
Gambling losses aren’t subject to the itemized deduction rules for pre-2018/post 2026 (miscellaneous itemized deductions are suspended for those tax years.). They’re also not subject to the pre-2018/post-2026 overall limitation on itemized deductions (also suspended for 2018-2025 tax years).
To show that you’re entitled to a deduction for gambling losses, make sure to document all your wagers. That should include the cost of your lottery tickets and any other wagering you do, like betting on ballgames, races, casino games, etc.
Make sure to keep receipts for tickets, wagers, canceled checks, credit card charges, losing tickets, etc. And do that for all the years you receive lottery installment payments. In some cases, the IRS has allowed taxpayer estimates, but it’s not a good idea to rely on that.
Q. When are lottery winnings taxed?
A. You report your lottery winnings as income in the year — or years — you actually or “constructively” receive those winnings. If you win a non-cash prize, the year would be the one in which you receive the prize. With cash winnings, if you’re required to take the winnings in annual installments, you only report each year’s installment as income for that year.
If you can choose between a lump-sum payment and a series of installment payments, when your winnings are taxable depends on when you made that choice.
If you had to make the choice when you bought the ticket, you include your winnings in income only when you actually receive them.
In that case, if you chose the lump-sum arrangement, you must include the entire lump sum in income the year you received the money. If you chose the installment arrangement, you must include the annual payments and any amount designated as interest on the unpaid installments in income as received.
On the other hand, if you’ve already won and you can still choose between a lump-sum payout and installments, reach out to us so we can help you decide with choice is better for your and your situation.
Q. How much is withholding?
A. If you win more than $5,000, you have to withhold 24% from your winnings for federal income tax purposes. The payor will send you a Form W-2G that shows the amount of lottery winnings you got during the year and the amount of federal income tax withheld.
The payor will also send this information to the IRS. So, you’ll need to provide them with your Social Security number. They might use a W9 to request your SS number. If your state requires income tax withholding, you’ll also see that amount on Form W-2G.
Q. What about estimated taxes?
A. Since your federal tax rate can be as high as 37% — which is well above the 24% withheld — the amount of tax withheld from your lottery winnings might not cover your federal tax bill. If that’s the case, you may need to make estimated tax payments in advance, and you might have to pay a penalty if you don’t.
Also, you might owe state and local income taxes, so you might have to make estimated payments on those as well.
If you need help deciding if you should be making estimated tax payments, please let us know.
Q. What if you share ownership of a winning lottery ticket?
A. If you’re sharing a lottery prize with friends or family or co-workers, you might still have to pay tax on the entire amount. It all depends on the sharing agreement.
The key is to establish that multiple people owned the ticket before it was declared a winner. If you can do this, the co-owners of the ticket each report only their individual shares as income.
If you can’t prove co-ownership — or if you give away part of your winnings — you’ll be subject to income tax on the full amount of the prize. You’ll also be treated as having made a gift of the part of the prize that you give away, and you may be subject to a separate gift tax. The gift tax could be as much as 40% of the gift, depending on the amount you gave and certain other circumstances.
The IRS will likely question the validity of a claimed co-ownership arrangement if the co-owners are all members of the same family. In that case, it’s important that you can document that there was a co-ownership arrangement before the lottery ticket became a winner.
Q. What happens if you sell the rights to your lottery payment installments for a lump sum?
A. Some companies will pay a lump sum to lottery winners in exchange for the winners’ rights to future installment payments of their lottery winnings. If you enter into such a transaction, you must include the entire lump sum you receive as ordinary income — not capital gain — in the year of the transaction.
The amount of any lump-sum payment offered to you depends, at least in part, on a “discount rate” that’s ordinarily determined by negotiation. A discount rate is an interest rate used to determine how much a series of installment payments is worth now. A lower discount rate means a larger lump sum for you now; a higher rate means a smaller lump sum now.
If one of these companies has approached you, please contact us before you accept any offer. These offers require careful evaluation. We can help you determine if it’s in your best interests to sell your rights and, if so, help you negotiate the best deal.
Q. What happens if I get divorced?
A. Divorces after one spouse wins the lottery can be tricky, and there are can be severe tax consequences.
For example, a lottery winner agreed to turn over half of each annual installment to his ex-spouse in one case. But he did so in a way that left him liable for income tax on the entire amount of each installment.
If you find yourself in divorce proceedings, we can alert you to all the tax consequences involved and advise you about the best way to protect your interests.
Q. How does estate tax work on lottery winnings?
A. If you’re entitled to receive annual installments of a lottery prize over several years, it’s possible you could die before the end of the payout period. In that case, the “present value” of the unpaid installments will be part of your estate.
That can cause your estate to be subject to estate tax or may significantly increase the amount of estate tax due. However, because these unpaid installments have not been paid yet, your estate might not have the cash to pay the tax on the includable amount.
You might also be able to reduce your estate tax depending on the method used to value the unpaid installments. For example, you could take a discount to reflect state-law restrictions on your right to transfer your interest in the payments.
Regardless, proper planning can help you make sure your heirs don’t run into any problems.
If you find yourself on the fortunate end of a lottery windfall, it’s a great idea to review your entire estate plan. This is especially true in light of changes to the estate tax in the Tax Cuts and Jobs Act passed in 2017.
We’re here to help you navigate your future and minimize any tax issues, no matter how big you win!