Winning the lottery will certainly have some income tax implications you'll have to deal with. And even though it may be a smart idea to pay off your mortgages with the lottery winnings, doing so won't present any tax savings for you. In fact, it may prevent you from taking a mortgage interest deduction on your homes in future years.
Taxable Lottery Winnings
The federal government taxes your gambling winnings, which includes all lottery prizes, at the same ordinary income tax rate it uses for your salary and business earnings. As a result, you must report the lottery payments received each tax year on the “Other income” line of your 1040. When reporting the lottery payments, you can't take any deductions or exclusions for amounts used to pay down your mortgages. Ultimately, you'll incur income taxes on the full amount of your lottery winnings. But unlike your employment and business earnings, you won't owe Social Security or Medicare taxes on the winnings.
State lottery agencies have an obligation to report the annual winnings paid to you on Form W-2G. Like the W-2 you may receive from an employer, the W-2G must be attached to your return when you file it and has a number of reporting boxes. Box 1 reports the total lottery payments, while Box 4 reports the amount of federal income tax withheld – which you'll in turn report in the payments section of your return to reduce the tax you owe. State and local governments can tax your lottery winnings and may require withholding as well. Boxes 15 and 17 will report the amount of state and local income tax withheld, which you may need to report on any state and local tax returns you file. These tax payments are also eligible for a deduction if you itemize on your federal return.
Deducting Gambling Losses
If you don't usually itemize deductions, you may want to consider it since it's the only way to take advantage of a deduction for any gambling and lottery losses. When reporting any type of gambling income on your return, the Internal Revenue Service lets you deduct losses up to the amount of the winnings reported. Your gambling loss deduction can include the money you lost on your Vegas trip, playing the lottery and virtually all other forms of legal gambling wagers you lost.
Once you receive the lottery winnings – reduced for the withholding of various income taxes – you may decide to pay off all of your mortgage debt. If you do, you won't incur additional taxes, but realize that you can't deduct mortgage interest in future years when you're no longer making payments. This may initially seem like an undesirable situation, but it's likely that the interest payments were still costing you more than what you save with the deduction. For the tax year in which you pay off the mortgage loans, you may have a substantial amount of deductible interest reported to you on Form 1098. However, if your lottery winnings are substantial, you may be denied the deduction because of the alternative minimum tax, which targets higher-income earners and reduces the tax breaks they can receive.
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.