How do I avoid paying taxes on prize winnings?

5 ways to avoid taxes on lottery winnings Consider lump-sum vs. annuity payments. ... Charitable donations. Donating some of the lottery money to charity will reduce your tax bill when you're a big winner. ... Gambling losses. ... Other deductions. ... Hire a tax professional.

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FinanceBuzz is reader-supported. We may receive compensation from the products and services mentioned in this story, but the opinions are the author's own. Compensation may impact where offers appear. We have not included all available products or offers. Learn more about how we make money and our editorial policies . Lottery winnings are taxed by the federal government and by many state governments, but there may be steps you can take to avoid them. Buying lottery tickets isn't always the best move to make with your money because the odds are against you. But it's fun, and someone has to win. If you end up being the person who hits a jackpot, you shouldn’t forget your obligations to the government. You will owe federal income taxes on lottery winnings and, depending on where you live, your state may want a cut of your money as well. The good news is that you may have options to keep more of your money and give less to the IRS. You just need to be smart about the techniques you use to reduce taxes on lottery winnings.

How are lottery winnings taxed by the federal government?

The Internal Revenue Service considers lottery winnings to be a form of gambling winnings. You'll receive a Form W-2G reporting your winnings and you must report the money you received from a lottery payout as “Other Income” on your 1040 form. If your lottery winnings exceed $5,000, they're subject to a 24% federal withholding tax. This means taxes are taken directly out of your winnings and you may need to claim a refund if too much is withheld (or pay more if too little is withheld). Your lottery winnings are taxed as ordinary income. This means the amount you will pay depends on your tax bracket. Tax brackets are progressive, and the more money you earn, the higher your bracket. Taxpayers don't pay taxes at the highest rate on every dollar they earn, though — just on income that falls within the threshold for that tax bracket. In some cases, lottery winnings could push you into a higher bracket. This means that you end up owing more taxes on it. For example, in 2021, these are the marginal tax rates that apply to income:

35%, for incomes over $209,425 ($418,850 for married couples filing jointly)

32% for incomes over $164,925 ($329,850 for married couples filing jointly)

24% for incomes over $86,375 ($172,750 for married couples filing jointly)

22% for incomes over $40,525 ($81,050 for married couples filing jointly)

12% for incomes over $9,950 ($19,900 for married couples filing jointly)

10% for incomes of $9,950 or less ($19,900 for married couples filing jointly)

To understand how this works, let's look at a simple example:

If you normally earn $45,525 as a single tax filer, just $5,000 of your income would be taxed at 22%. Your income between $9,950 and $40,525 would be taxed at 12%, and income below $9,950 would be taxed at 10%. But if you had a $100,000 lottery win, your total income would go up to $145,525. You would be pushed up into the 24% tax bracket for all of the income you have over $86,375 and would also pay 22% on a lot more money — every dollar of winnings that falls within the income range this bracket applies to. If you qualify for means-tested tax credits or deductions, such as the Earned Income Tax Credit, lottery winnings could end up causing you to lose out on these tax savings opportunities for the year.

How are lottery winnings taxed at the state and local levels?

Although federal tax rules apply across the U.S., state and local taxes are a lot more complicated. That's because each state and local government sets its own rules for how lottery winnings are taxed. In the states with no income tax — including Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming — you won't have to worry about state taxes on lottery winnings. Some states, such as California, don’t tax lottery winnings. But in other states, you'll be taxed at your ordinary income tax rate. Most states that impose taxes on your winnings require some money for those taxes to be withheld upfront before you receive your winnings. For example, the Tax Foundation reports that Arizona requires 5% of the prize to be withheld for residents and 6% for non-residents. Connecticut has a 6.7% withholding rate.

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Check your state and local department of revenue website to find out its rules on lottery taxes.

5 ways to avoid taxes on lottery winnings

Once you've won a jackpot, it's worth exploring these five techniques for reducing or avoiding the taxes that you could owe on the money you make.

1. Consider lump-sum vs. annuity payments

Lottery winners typically have two choices for how to collect their prize depending on how much they won and what the state's tax rules are.

The two options for receiving lottery prizes are typically:

A lump-sum payment, which is received all at once

An annuity payment, which is paid out over time in annual installments

A lump-sum payment is usually a much smaller amount than the actual jackpot. For example, if the Powerball jackpot was $228.4 million, the winner would typically get a lump-sum payment of around $134 million. But, if they opted for the annuity, they'd receive the full $228.4 million but it would be paid out over 30 years. When a lottery winner chooses a lump-sum payment, they take care of paying all of the taxes at once in the year the payment is received. This would obviously mean a huge chunk of the money is taxed at the highest tax rate because they're getting a large amount all at once. But the benefit of this approach is certainty. They know exactly what rate they're being taxed at. If a lottery winner chooses an annuity, they receive annual payments over time. They may not be taxed at the highest rate, depending on how much they get each year. But the downside is that they face the uncertainty of not knowing what their future taxes will be. If tax rates go up, they could end up paying taxes on a lot of the money at a higher rate.

2. Charitable donations

Donating some of the lottery money to charity will reduce your tax bill when you're a big winner. That's because you can usually deduct charitable contributions from your taxable income. However, there is a limit on the value of your charitable deduction relative to your adjusted gross income. In many cases, your deduction for your contribution is capped at 60% of your adjusted gross income. However, the limit can sometimes be lower if you're making contributions of property subject to long-term capital gains taxes. If you reach the limit of how much you can deduct for your contribution, you may be able to carry it forward and claim some of the deduction in a later tax year. You also must itemize your taxes to claim charitable donations as a deduction.

3. Gambling losses

If you itemize your deductions, you may be able to deduct gambling losses to offset the gambling income you report on your tax return. You will need to have a record of your losses. Your gambling losses can only be deducted against your winnings. If your losses exceed your winnings, you can’t apply those losses to the rest of your taxes.

4. Other deductions

Because lottery winnings are simply part of your income, you may be able to reduce the amount you're taxed on by taking other deductions. You could claim the standard deduction, which is a set amount based on your filing status. It's $25,100 for married joint filers and $12,550 for single tax filers in the 2021 tax year. Or you could itemize deductions, which means claiming tax deductions for specific things such as:

Mortgage interest

State and local taxes paid (up to $10,000)

Medical bills

Qualifying educational expenses

Contributions to certain retirement plans

For many lottery winners who become property owners and who may owe a lot of state income tax, using itemized deductions could make sense. Taking advantage of the best tax software could help you to identify all the potential deductions you could claim if you itemize.

5. Hire a tax professional

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When you are figuring out how to manage your money after a lottery win, calling in the professionals could be advisable. A tax expert can help you to understand the consequences of different decisions, such as choosing a lump sum or an annuity or itemizing or claiming the standard deduction. A tax professional may also have other tips on ways you could save on your lottery taxes, depending on the specifics of your financial situation.

FAQs

Is it best to take a lump sum or monthly payments for the lottery? Whether you should take a lump sum or an annuity depends on many factors, including: Whether you think tax rates will rise: Tax rates could change due to tax laws. Or you might anticipate being in a higher tax bracket down the road. If so, you may want to accept a lump-sum payment now so you can have the entire amount taxed at your current rate. Tax rates could change due to tax laws. Or you might anticipate being in a higher tax bracket down the road. If so, you may want to accept a lump-sum payment now so you can have the entire amount taxed at your current rate. Whether you expect to be responsible with the money: If you are worried about spending it too quickly, an annuity could be a better option. If you are worried about spending it too quickly, an annuity could be a better option. Whether you want to invest the money yourself: Taking a lump-sum payment allows you to invest the funds, which you could invest. An annuity, on the other hand, means you'll get regular payments over time with interest. Be sure to weigh the pros and cons and consider talking with a professional about your options. What is the best way to share your winnings with family and friends? For many, the best way to share winnings with family and friends is by giving them gifts. You can give tax-free gifts of up to $15,000 per recipient in 2021, or $16,000 per recipient in 2022. Some gifts, such as paying tuition or medical expenses, aren't taxable even if they exceed the annual exclusion. How do you protect your money if you win the lottery? To protect your money if you win the lottery, you should consider talking with financial professionals such as attorneys and tax professionals. They can provide you with advice on how to protect your winnings, such as by putting some money into a trust. You should also be careful about who you tell that you've won the money. And if you expect that you may face pressure to spend it quickly or you don't know how to invest it, you may be better off choosing to have the money paid out over time in an annuity rather than getting the payment as a lump sum.

Bottom line

Having that winning lottery ticket is exciting, but you need to make sure you protect your money by minimizing your tax burden and by exploring the best investment apps and other options that could help you earn reasonable returns on the funds over time. By getting the right professional advice and making smart decisions about how you receive and spend your prize, you could avoid lottery mistakes and make the windfall last for as long as possible — perhaps even preserving and growing your wealth for future generations.

financebuzz.com - 5 Tips for Avoiding Taxes on Lottery Winnings - FinanceBuzz

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