While we are all sadly aware that lottery winnings are subject to taxes - the next question is how? And how much? State and local government taxes on wins are different from the federal tax. Although not applicable in every state, several do tax lottery wins separate from the federal tax.
So how can you pay the tax on your win?
How are lottery winnings taxed?
For both federal and state tax purposes, lottery winnings are treated as ordinary taxable income. Therefore, your winnings are taxed the same as your wages. Your tax return must include the entire amount you receive every year.
Let's say you elected to receive your lottery winnings as annuities in 2020 and received $50,000. This money must be reported as income on your 2020 tax return. The same applies if you take a lump-sum payment in 2020. This amount must also be reported. For this, a tax calculator is an essential tool.
Tax money is automatically taken from your winnings by the IRS before you receive one dollar. When you file your tax return, you will have to pay the rest of your tax bill on that prize money.
What are the benefits of taking a lump sum payment versus annuity payments for tax purposes?
You have more control over your money if you take a lump sum. You may decide to invest it into a retirement account or other stock option to generate a return. It could also be used to purchase a business or expand one.
Many financial advisors recommend investing lottery winnings in higher-return assets, such as stocks, rather than taking the lump sum. With an annuity payment, however, you can take advantage of your tax deductions each year with the help of a lottery tax calculator and a lower tax bracket to reduce your tax obligation.
Deciding which option is better can be challenging. It depends on the size of your lottery winnings, your current and projected income tax rates, where you live, and the potential return on any investments. When you win big, you should work with a financial advisor to determine what's best for you.
How do you pay taxes on lottery winnings?
Payment on winnings takes two forms. First, pay tax on the whole lump sum you receive. Or you pay tax on the amount you receive each year. How does this work? When you receive a lump sum up to $500,000, you'll get taxed up to 37%. On the other hand, if you choose to break it down, you'll be taxed based on the amount you receive annually.
Most lottery companies can agree to pay your winnings either at all once or in installments over some years. Your decision will determine how the company will pay, and tax, you.
How to Report Lottery Winnings on Your Taxes
From $600 upwards, the lottery company should send the W-2G for you to file with tax returns if the company has deducted the tax charge from the source. In case you do not receive the W-2G, it's imperative that you report this form of income to IRS on your income federal tax return form.
Whichever way you choose to receive the lottery win, you'll end up having an increased income that will put you in an increased tax bracket. And an increase in tax bracket means an increase in payment to the IRS.
Does winning the lottery affect my tax bracket?
If you win the lottery, it can drastically change your tax bracket. According to the IRS, a family's top federal tax rate could increase from 22 percent to 37 percent. However, bear in mind that you likely won't pay the top rate on all of your money if that happens.
If you are already in the top tax bracket due to your regular household income before winning, you will not fall into that bracket if you win. In that case, everything is subject to 37 percent tax. You can calculate this using a tax calculator. Your lottery winnings are included in your taxable income for the year, so money won is not taxed separately.
What is the tax rate for lottery winnings?
As mentioned above, apart from the federal tax the law in each state may require additional tax. By default, the lottery company is expected to withhold 24% of a win up to $5,000 and more. This percentage is paid to the federal government.
Based on the percentage deducted by the lottery company, the tax bracket your income moves you can earn you a refund.
As mentioned earlier, you may choose to receive a lump sum or spread the money over years. There are benefits to both types of payment. A lump sum gives you access to a large amount but with a high tax rate. However, the payment in bits limits your access to a huge sum but you'll enjoy a reduced tax rate. Let's use the table below to create an example.
The above shows the expected tax charge based on the tax bracket. A clear indication of the benefit that comes with the annual installment payment of lottery winnings. According to the tax bracket system, a lower income is subject to a lesser tax charge than a larger type. A win of $500,000 would incur more tax than an installment payment scheduled to pay at 40,000 over 10 years or more.
Can I change the amount of tax the lottery withholds?
You cannot choose how much state or federal taxes will be withheld from your winnings. There is only one thing you can control: how much money you save to cover any extra debt.
How to Minimize Your Tax Burden After You Win the Lottery
Lottery winnings are subject to taxes, but there are steps you can take to minimize the impact. If your award is small enough, you might be able to lower your tax liability by taking it in installments over 30 years.
You may also donate to your favorite non-profit organization. As a result, you can take advantage of certain itemized deductions, which can lower your tax bracket depending on your situation.
You'll also want to avoid paying a gift tax if you are sharing your good fortune with friends and family. Gifts up to $15,000 per person are tax-free in 2021. It's likely that you won't owe tax even if you exceed the limit. In 2021, the Tax Cuts and Jobs Act raised the lifetime gift and estate tax exclusion to $11.7 million for single filers ($23.4 million for married couples filing jointly). The lifetime exclusion will apply to amounts over $15,000 per individual per year.
Remember, however, that direct payments to colleges and universities are not considered gifts, nor are direct payments to medical institutions. Additionally, if you are married, you can each contribute $15,000 to a person, so you can give away $30,000 without paying gift taxes. Furthermore, if the recipient is married, you can give each spouse $15,000 tax-free, which means you can give a total of $60,000 to the couple.
Claiming tax deductions on lottery income
Deductions allow you to subtract certain amounts from your taxable income. A reduced taxable income ultimately reduces the tax charge to be paid. Deductions can be taken on charitable donations and gambling losses. Although terms and conditions apply, you can deduct a certain amount of a donation from your income. For gambling, losses can include the number of tickets that you didn't win, which are technically deductible.
Additionally, you can pay less tax when you play the lottery in a pool. By playing in the pool, only the amount payable to you is taxed. If you receive half or a quarter of the total win, tax is charged on the half or quarter share you receive. Of course, this means you'll earn less but pay less as well.
State and local taxes are applicable in the case of a lottery win. Some states tax your income after the federal tax. Further, the city where you reside may likely charge you after the state tax. However, not all states and cities do this. So, find out the requirements in your region.
Consulting with a professional
It can be exciting to win the lottery, but before you receive the winnings, consult with a financial expert to know what is due and how to pay. Above all, analyze your needs to decide if the lump-sum payment or the installment would be most beneficial.
Winning the lottery, especially if it's a large sum, can change the course of one's life. If you take the right steps, you can achieve financial wellness all your life long. Or it can take you on the roller coaster ride of your life, leaving you bankrupt.
Take the time to understand how your windfall affects your finances. Estimate your tax liability with an accountant and set aside a minimum amount to cover the tax bill. The next step is to create a blueprint of how you will handle the rest of the cash.
Be sure not to do this alone. Consult a qualified financial advisor who can help you preserve and grow the money. No matter how much money you win, it isn't endless. To have enough money for the rest of your life, you need to make smart investments.
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