Winning prize money can be an overwhelmingly positive experience. Whether the influx of cash gets you out of debt, allows you to live out some of your dreams or have other amazing experiences, prize money can change your life for the better. However, what some people fail to realize in the euphoria of getting the instant “free money” is that the IRS sees the prize funds as income, and you are responsible for paying income taxes on your winnings.
For the most part, all game show rewards, gambling winnings, raffle prizes and lottery winnings are taxable. So, avoid financial frustration later by calculating taxes on your prize money right away and setting those funds aside until you can pay them to the IRS.
Choose How to Be Paid
Most people who win the lottery choose a lump sum payment up front, but you’ll ultimately make more money if you take the annuity option. Getting paid the prize money over decades isn’t appealing to many people, though.
How much taxes you’ll pay depends on which payment method you choose, too. You will be taxed on the full amount of a lump sum that’s paid to you. With an annuity, you will be taxed each year on the earnings. That could end up working in your favor if there are different laws in the future that offer tax breaks to people in your position. It could go both ways with stricter laws resulting in greater taxes in the future or tax laws that don’t take as much of the winnings.
Add Winning to Your Earnings
Your prize winnings are calculated along with your regular earnings for the year to determine which tax bracket you will be in. In other words, you will be taxed on your prize money according to how much money you made overall in the year when you add the reward money to any other form of income you received.
Get all your income paperwork together. Estimate how much money that you’re likely to earn for the year. If you’re a salaried employee who earns an established annual salary, that may be easier since you may know how much money you are likely to earn for the year. If you work full-time hours for the entire year at an hourly wage, multiply your hourly pay rate by 40, then multiply that figure by 52. If you earn overtime, it is best to go ahead and estimate any overtime earnings, too. The more you report now, the more you may get in a refund later. For many people, that is much better than discovering that money is owed when filing taxes for the year.
Know Your 2018 Tax Law
The IRS requires that 25 percent of prize money over $5,000 be withheld before payment is given to the winner. That can be tricky when it comes to prizes that aren’t paid in the form of money. For example, if you won an exciting, luxury vacation, you may have to pay 24 percent of its cash value to the IRS before you can claim your prize. Before December 31, 2017, that amount was 25 percent. The specifics can vary, but that’s the typical situation. Keep in mind that you will probably owe more than the 24 percent that’s withheld, but that is the minimum the IRS deducts right from the start.
The company or organization that paid your prize money is required to file Form W2-G that will inform you and the IRS of the funds that were earned. Also, you will receive Form 1099-MISC near the start of the following year when it’s time to file your taxes.
The standard deduction you can take for 2018 tax deductions increased significantly from the previous year. The single standard deduction is $12,000. For the head of the household, it increased to $18,000. For people who are married filing separately, it was $12,000, while those who were married filing jointly had a deduction of $24,000. Qualifying widows and widowers also have a standard deduction of $24,000.
Explore Your 2017 Tax Law
If you are filing taxes for prize money that was earned before December 31, 2017, keep in mind that 25 percent was likely deducted from your prize before you received the funds.
Also, the standard deduction for the 2017 tax year was $6,350, and it was $9,350 for those filing as the head of household. For married people filing separately, it was $6,350, while it was $12,700 for married filing jointly and qualifying widows/widowers.
Subtract Your Deductions
Subtract your deductions from your annual income that includes both your earned income and your prize money. First, decide whether you are doing standard or itemized deductions. If you’re just doing a quick summary to get a basic idea of how much you’ll need to pay on taxes for your prize money, you may want to take standard deductions and continue the paperwork unless you know that your itemized deductions will provide a drastic change in taxable income.
Choose the Right Tax Bracket
After you subtract your deductions, you’ll have your taxable income for the year. Next, find the right tax bracket for your income and marital status in IRS Publication 17. If you’re used to calculating taxes based on a low tax bracket, keep in mind that the prize money may have elevated you to a much higher tax bracket. Also, if all the calculations are overwhelming, you may be wanting a taxes-on-prize-winnings calculator. Well, the IRS offers a tax withholding calculator that you can use to help you determine how much needs to be set aside for the government. It doesn’t exclusively serve as a prize tax rate calculator, but it is easy to use for that purpose.
Calculate State Taxes
Federal taxes aren’t your only concern after winning the lottery. You most likely will pay state taxes, too. Wyoming, Florida, Texas, Tennessee, South Dakota and New Hampshire don’t have state income taxes, but they are the exception. Also, California, Pennsylvania and Washington don’t tax lottery winnings. Otherwise, most states require you to pay up, but the rate varies by state. In most states, taxes are deducted automatically on all prize money over $5,000. Sometimes where you are within a state can even impact the taxation. For example, if you live in New York City or Yonkers in the state of New York, you may be facing additional taxes that other state residents don’t have to pay.
Pay Nothing in Puerto Rico
If you live in Puerto Rico, you don’t have to pay federal income taxes or territorial taxes on prize money. So, if you win the lottery or strike it right gambling, you’re safe from doling out a lot of money to Uncle Sam. Also, if you live in the U.S. Virgin Islands, you won’t be paying taxes on lottery money.
Set Aside Extra Funds
Start a separate account for the money you plan to spend on taxes. That can help you identify the funds as separate and not available for spending. Do your best to set aside more money than you think you’ll need for tax purposes. It’s better to have extra money after you’ve filed your tax return than to have to scramble to pay more for taxes than you anticipated.
- If you own a business and expect a loss for the year, subtract your estimated loss from your adjusted gross income before determining your tax.
- Your final tax obligation will vary based on a number of factors, including whether you own a home, how much you earned on interest and investments during the year, how much you donated to charity, and whether you qualify for tax credits such as the Earned Income Credit or Child Tax Credit.
Robin Raven is an experienced journalist and author. She has a BFA in writing from the School of Visual Arts and loves to write about personal finance. She has contributed to USAToday.com, The Huffington Post, The Nest, Grok Nation, and many other publications.