If you won the lottery, congratulations! This is probably one of the most exciting days of your life. But with great reward comes great responsibility. In this case, that responsibility is taxes. You only have 60 days to decide if you will take a lump-sum payment, which is one check for the single amount after federal taxes have been withheld, or an annuity, which is smaller annual payments that equal the total winnings. Even if you haven’t won yet, it is still a good idea to learn about what winning can do to your taxes. Here are some answers to your most burning lottery tax questions, and some ideas for protecting your newly acquired wealth.
Should I take the lump sum or the annuity?
From a tax perspective, choosing annual payments will place you in a lower tax bracket that year. This will reduce your tax liability. However, there is a strong chance that taxes will go up over the years. If you win the Mega Millions or any other lottery, it is better to take the lump-sum. It may seem like less money up front, but if you take the annuity the lottery is only required to pay you 4.5% of your earnings per year. It will take you a long time to receive all of your winnings, especially if you win millions. If you take the lump-sum, be sure to hire a financial advisor so you don’t make the same mistakes as so many of the previous winners. Consider immediately investing the lump-sum, and let your investments begin collecting sooner.
What federal taxes will I have to pay with a lump-sum payment?
Usually, 25% of the lump-sum will be withheld for federal tax. This is typically less than what you will owe the government. File a return with Form W-2G that reports your winnings to the IRS. Your filing status, married filing jointly, single, etc., will determine how much tax you will owe in April.
What federal taxes will I have to pay with the annuity?
If you opt to take annual payments, each installment will be taxed when you receive it. You will still owe more in April than they took out of each payment.
Will I have to pay state taxes on my winnings?
Yes. If you live in Alaska, Florida, Texas, Nevada, South Dakota, Washington, or Wyoming, you have to pay state taxes on your winnings. If you live in any other state, each one ha their own income tax, which means you could owe up to 10% more.
How do I minimize my tax liability?
Use the money to donate to charities. Then itemize your deductions and lower your tax liability. Or gift portions of the money to friends and family. You can give up to $15,000 per person per year before the gift tax applies. You can also put your money in a trust. If something happens to you, this will minimize taxes on your estate.
What is a trust?
A trust allows a third party, known as a trustee, to hold financial assets on behalf of a person, known as a beneficiary. There are several kinds of trusts and ways to set them up. Trusts avoid settling an estate by testing the person’s will, which is known as probate. A trust clearly defines who will receive which assets in case of death and how taxes and debt will be paid. This allows your family and friends to acquire these assets more quickly. If you win the lottery and it is a significant sum, setting up a trust for any remaining money you don’t donate or spend will help your family in the future and also protect the money while you are living.
Should I invest my winnings?
Whatever money you don’t decide to donate, gift, or place in a trust you can invest. If you do this correctly, you might not have to work a normal job anymore. But are you prepared to pay taxes like a millionaire? If you invest a portion of your winnings, the money you receive from these investments will be taxed as capital gains. This is a different tax rate than normal income. Read more here.
This article is up to date and accounts for tax law changes for tax year 2018 (tax returns filed in 2019). Learn more about tax reform enacted under the Tax Cuts and Jobs Act here.