When you owe back taxes, the Internal Revenue Service uses a number of methods to collect the money from you if you don't pay voluntarily. If you win the lottery, your prize is always taxable, and the state lotto agency that pays the prize may have an obligation to report your winnings to the IRS and withhold taxes from it. But even after the appropriate taxes are withheld, the remaining lottery winnings may still be vulnerable to IRS collections.
Tax Withholding on Lottery Prizes
State lottery agencies are required to withhold 25 percent of your winnings for federal income taxes if the total prize minus your wager is more than $5,000. This 25-percent withholding rate applies to all taxpayers, regardless of whether back taxes are owed or not. The amount withheld from your lottery winnings is treated as an estimated tax payment and doesn't usually reflect the amount of income tax you'll actually owe. As a result, you may overpay and be due a refund that's taken from you to pay your back taxes and other debts.
Special Backup Withholding
If you don't provide the lottery agency with your correct Social Security Number or other Taxpayer Identification Number, you may be subject to the 28-percent backup withholding rate on a portion of the winnings. This 28-percent rate applies to the first $5,000 of winnings if the total payment is $600 or more and is at least 300 times the amount of your wager. Your winnings in excess of $5,000 are still subject to the 25-percent withholding rate.
Your Form W-2G
Your lottery winnings are reported on Form W-2G by the state lottery agency for prizes of $600 or more that are at least 300 times the amount of your wager. For example, a W-2G is only required for a $3 lotto ticket if you win at least $900, though a $900 prize doesn't require withholding. The W-2G, which must be attached to your return, reports information such as the prize amount, the date you won it and the federal, and possibly state and local, income taxes withheld from your payment. If you itemize, you can reduce the amount of your taxable lottery winnings with a deduction for some or all the gambling losses you incur in the same year.
Refund Offsets and Collections
When you owe back taxes, the IRS will keep all refunds and apply them toward your unpaid tax balance. And once your federal taxes are paid off, refunds may continue to be withheld from you to pay state and local back taxes, child support and certain other outstanding debts you owe to government agencies. Before or after you win the lottery, the IRS can always place liens on your personal property and eventually enforce a levy – a seizure of your property – on as much property as it needs to pay off your taxes. Also at risk are your bank accounts, so if you deposit your lottery winnings in one of them, the IRS has the authority to take every dollar needed to satisfy your back tax debt.
Michael Marz has worked in the financial sector since 2002, specializing in wealth and estate planning. After spending six years working for a large investment bank and an accounting firm, Marz is now self-employed as a consultant, focusing on complex estate and gift tax compliance and planning.