If you beat the odds and win the lottery, before you start dreaming of buying diamonds and vacation homes, you’d be wise to tend to basic financial planning. Tax planning will certainly be a major part of getting your finances in order after you hit it big. Although you’ll need to carefully plot your spending after a lotto win, your decision of whether to take an annuity or a lump-sum cash payment for your winnings probably won’t have much impact on your tax situation.
Lottery Winnings and Taxes
The Internal Revenue Service taxes lottery winnings as regular income, so it’s likely that whatever form you choose to take your jackpot, you could land in the highest tax bracket: As of 2012, everyone who earns -- or wins, in the case of a lottery -- more than $388,351 is taxed at the highest rate, 35 percent. If you’re married and file separate returns, that threshold drops to $194,176. Because of this, any annuity spread equally over 20 years that’s worth more than $7,767,020 will land you in the highest tax bracket, effectively taxing you the same as if you took the lump-sum payment.
Playing the Angles
Because you play the lotto, you’re clearly a gambler, and you’ll have another opportunity to take a risk when you choose your cash or annuity, and gamble on future tax brackets. If you think Congress will alter the tax code to lower the upper tax bracket’s rate or raise the limits on earnings for higher brackets, you can choose an annuity and bet on more favorable tax treatment in the future. Of course, like every gamble, this strategy might not pan out, and you could end up owing more taxes in the future. The 35-percent rate has been the lowest tax rate for the upper bracket since 1992, as of publication.
If can hypothetically invest your lump sum to receive a return that would equal your winnings if you took the annuity, you’ll also have to contend with another wrinkle in the tax codes: capital gains taxes. Annuity payments deliver a fixed sum that’s taxed at the top rate, say 35 percent, for the life of the annuity. Your lump-sum payment will be taxed at that rate, then any investment earnings will face capital gains taxes: As of 2012, you can expect to pay between 20 and 28 percent on your profits if you’re in the upper tax brackets.
The tax implications of your winnings should guide your decision to choose between an annuity or a cash payout, but there are other issues to weigh before you make your decision. While you’ll want to meet with a financial planner, you’ll need to consider issues such as the flexibility that a lump-sum payment provides versus the long-term stability of an annuity, as well as investment opportunities that each scenario presents.
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