The dark side of winning the lottery is the possibility of a huge unexpected tax liability. Both the IRS and state governments tax lottery winnings, and the IRS might even require that your taxes be withheld from your prize before you receive it. You can reduce your tax liability, however, with smart financial planning.
Most lotteries allow winners to choose between taking a lump sum and receiving payment in annual installments. If you choose payment in lump sum the amount of your prize will be discounted significantly, because if you had chosen annual installments the lottery administrator would have invested the unpaid balance. If you take your prize in lump sum, you will be taxed on it for the tax year during which you claimed the prize. If you take your prize in installments, you will be taxed as gradually as your prize is distributed to you. For this reason, many financial professional advise winners of large lottery prizes to choose payment in annual installments.
Depending on how much you make and how much money you won, you may be kicked into a higher tax bracket by winning the lottery. If your prize is large enough, you may end up paying the maximum income tax rate even if you choose to take your winnings in annual installments. However, if your income is low enough and your prize is small enough, you may be able to avoid the highest tax bracket by taking your prize in annual installments instead of lump sum.
You can use money for more than just spending -- you can invest it and make money that is taxed at a substantially lower rate than ordinary income. If you purchase investment property, such as corporate shares or real estate that you rent out, any profits that you realize from selling these investments will be considered capital gains by the IRS. As long as you hold the asset for at least a year before you sell it, your profit will be taxed at special capital gains tax rates that top out at 15 percent. If you invest enough to make a living from taxable gains, you will pay less in taxes than many people who make much less than you do.
When you make a gift to an individual other than your spouse, you become liable for gift tax on any amount exceeding the gift tax exclusion -- $13,000 per beneficiary per year in 2012. When you donate to an organization qualified under Section 501(c)(3) of the Internal Revenue Code, however, you are liable for neither income nor gift tax on the amount of your donation. This exclusion applies to annual donations of up to 50 percent of your adjusted gross income in most cases. Most nonprofit schools, hospitals, churches and public charities qualify. While donating to a qualified organization won't result in a net savings unless the tax deduction kicks you into a lower tax bracket, it will reduce your total cost of giving.
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- Winner image by Warren Millar from Fotolia.com