As a lottery winner, one of the big questions is whether to take the lump-sum option or multiple annual payments. Your choice will have some tax implications, since all lottery winnings are considered taxable income by the Internal Revenue Service. Pursuant to federal law requirements, each state sponsoring a lottery -- currently, 43 states and the District of Columbia -- withholds federal income taxes. Some may withhold state income taxes as well. However, the nominal amount withheld may not sufficiently discharge your total income tax liability for that year.
Federal Taxes with Lump-Sum Payment
Your winnings will be taxed as ordinary income when received. Depending on the jackpot and your total income, Uncle Sam may want up to 39.6 percent of the prize. Typically, 25 percent will be withheld from your check for federal tax, although this is less than what you’ll owe the government. You'll have to file a return based on the Form W-2G that reports your winnings, which both you and the IRS receive. Your filing status will determine your tax liability.
Federal Taxes with Annuity Payments
Under IRS rules, any prizes you win in contests are taxable at the marginal tax rate. In general, you have 60 days after winning to decide on how to take the money: a lump-sum or an annuity. Electing to take the winnings in annual installments will not result in immediate income taxes being levied on the full amount. With installment payments, each lottery payment will be subject to income tax only as and when received.
Unless you're a resident of Alaska, Florida, Texas, Nevada, South Dakota, Washington or Wyoming, you'll have to pay state taxes on your lottery winnings. The rest of the states have their own income tax, as do many local governments. These entities could easily skim another 10 percent off your lottery winnings.
Minimizing Tax Liability
You may donate to charities you feel strongly about. Come tax time, you can itemize your contributions to lower your adjusted gross income and thus your tax liability. You may also consider gifting some of the money to family and friends. This money won't be subject to a gift tax if it doesn't exceed the annual exclusion limit, which is currently $14,000 per recipient. You may gain some tax advantage by holding your lottery winnings in a trust. This will avoid probate of the lottery proceeds in the unfortunate event of your demise, minimizing taxes on your estate.
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