A big lottery jackpot win is a time for celebration, but it's also a taxing time. States offer winners a lump-sum payout option, which many winners choose instead of annual installments. Uncle Sam will join the celebration of your big win because lottery winnings are taxable. Winnings over $5,000 are subject to mandatory income tax withholding. Further, state lottery agencies must report any win over $600 to the Internal Revenue Service.
Big Tax Bite
When you receive a lottery jackpot, the state lottery agency must withhold 25 percent for federal income taxes. In 34 states, the lottery agency will also withhold state income tax. State withholding rates in 2012 ranged from 3.4 percent to 10.8 percent. The other 16 states don’t tax lottery prizes, have no lottery or have no income tax.
Set Some Aside
Lump-sum lottery winnings are taxable as ordinary income in the year the prize is won. There is no reduced tax rate for lottery jackpots. As of 2012, the top federal income tax rate is 35 percent, applied to all taxpayers regardless of filing status if taxable income exceeds $398,350. But the lottery agency withholds only 25 percent, so you may find yourself stuck with a big tax bill when you file your taxes for the year unless you set some jackpot money aside.
The income tax on the prize money is affected by whether you claim the lottery prize as an individual or on behalf of a group such as an office lottery pool. Most states permit only one payee per winning ticket. Legal experts at the American Bar Association advise that if your winning ticket was from a pool or other group, don't cash in the ticket until you and the other members create a formal legal entity such as a partnership or trust to claim and distribute the prize. Otherwise, you as an individual could be liable for the entire income tax bill when you make the claim and might even be stuck with additional gift taxes when you distribute the prize money. With a legal entity, each member will owe tax only on his or her share of the jackpot.
Lottery winners who share their jackpot by giving generous gifts to relatives may find they owe gift taxes on top of income taxes. Federal law taxes gifts to individuals that exceed $13,000 per recipient per year. The giver is the one liable to pay the gift tax. In addition to the federal gift tax, some states impose state gift taxes. To avoid gift taxes, you and the relatives who will share in the prize should make a written sharing agreement before cashing the ticket.
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