Taxes on Lottery Annuities

Judging by ticket sales, millions of people are willing to risk a few dollars to win a big lottery. But before you claim your prize, you should consult with tax and estate expert on whether to take your winnings in annual installments from an annuity or in a lump sum. Federal taxation of lottery annuities can involve complex issues. Depending on where you live, you may also have to contend with state taxes on your annuity.

Annuity Payouts

In general, lottery payouts are taxed as ordinary income in the year you receive the money. If you choose the annuity option with payments typically spread over 20 to 30 years, each annual payment is taxed in the year you receive it. Lotteries automatically withhold 25 percent of payments for federal taxes but that may not be enough. In 2013 the top federal income tax rate is 39.6 percent. Taxes on the unpaid prize money in the annuity are deferred until the money is paid to you or until you die.

Deferral Exception

The deferral rule on unpaid balances has an exception. If your state lottery requires that you elect lump-sum cash or an annuity at the time you claim your prize and you choose the annuity, you could be taxed on the entire annuity value in the year you won, even on the money you haven’t received yet. But if your state adopted the “qualified prize option” that gives you 60 days to make the decision, after which you chose the annuity, you would pay tax only on each annual payment as you receive it. If you don’t act within the 60-day window, however, you would face tax on the entire annuity balance at once, no matter which payout option you choose.

Estate Tax Bite

States will make annual annuity payments to you and then to your heirs until the money runs out. If you die before receiving all your annuity payments, your estate and heirs could face a whopping death-tax bill on all the unpaid money remaining in the annuity. That tax would be due all at once in the year of your death. In effect, your estate and heirs would owe tax today on money that won’t be paid for years to come. But if your state lottery permits payment of the present value of the outstanding annuity balance as a lump sum to your estate, your heirs can obtain the money to pay the death taxes.

Value Basis

The federal estate tax of up to 55 percent will be based on the discounted present value of the future lottery payments as specified by federal annuity value tables, minus a $5.5 million exclusion as of 2013. For example, assume the present value will equal about 60 percent of the value of the future lottery payments. If you died with $50 million left in your lottery annuity, your estate could face federal and state estate taxes on around $30 million, minus the $5.5 million exclusion, for a net taxable value around $24.5 million. But if your state lottery prohibits selling the unpaid annuity balance to a third party or using the unpaid balance as collateral for a loan to pay the taxes, the estate can argue in court for a discount from the federal tax table value.

Estate Planning

If you intend to choose the annuity payout, consult a lawyer experienced in estate planning who can advise you on legal tactics to reduce or cover the federal and state estate taxes on your heirs. Tactics include different types of trust or partnership arrangements, where the trust or partnership claims the lottery prize for the benefit of you and your family members. A trust or partnership doesn’t die, so estate taxes don’t exist.

Insurance and Gifts

You can set up an irrevocable life insurance trust into which you pay a portion of each year’s lottery payments as a premium on a life insurance policy owned by the trust that pays the estate taxes when you die. You can make gifts to charity and to individuals in your will to reduce the taxable amount. But beware of the federal gift tax that may be billed to your estate on gifts to individuals other than your spouse. As of 2013, this levy applies on gifts to individuals that exceed $14,000 per year.