December 6, 2013

Who wins after every lottery draw? The taxman does, of course!

Not only is the lottery a tax on people who are bad at math –US lotteries generally only pay out 60% of the money players bet. The chances of winning a large lottery, such as the Powerball, is one in 175 million and the lucky winner actually has to give the IRS and state tax revenue agencies a big chunk of the prize, every time.

How big a chunk? The taxman’s share could be anything from 40% to 60%, depending on how the winner decides to cash in the prize and if they live in a state that taxes lottery winnings. The same applies even if you win a small prize, win on a game show, or participate in a community raffle.

Lottery Winners: What’s Next?

So how does paying taxes on lottery winnings work? And if you do happen to win the lottery, what is the smartest way to minimize your tax burden?

Lump Sum Vs. Annuity

The first tax decision lottery winners have to make is whether to receive their prize as a lump sum or have it paid out in yearly installments. If you win a $10 million prize with the New York State Lottery, for instance, you get to choose between $10 million over 26 yearly payments of approximately $250,000 or a lump sum of a little less than $5 million. The full prize is only for those who choose the annual payments.
Those who choose the lump sum get the cash value in bonds that the lottery would have had to buy in order to pay $10 million over 25 years.

From a tax perspective, choosing annual payments will keep you in a much lower tax bracket, which will reduce the amount of tax you have to pay. As of 2013, taxpayers with an income between $183,251 and $398,350 pay 33 cents on the dollar to the IRS. Those with an income of more than $400,000 have to pay nearly 40 cents on the dollar, which doesn’t even include state taxes.

Similarly, business owners whose profits swing dramatically from one year to the next may benefit from spreading taxable income over multiple years.

However, there is strong likelihood that taxes will continue to go up over time and negate the tax benefit of annuities. Also, if you choose the lump sum, you could invest the entire amount and put those lottery winnings to work, which — if your investments go well — could more than compensate for the higher initial lump sum tax rate.

“When deciding upon a lottery payment option it ultimately depends on the unique situation,” says Harry Langenberg, Managing Partner at Optima Tax Relief, who points out winners of big jackpots will be in the highest bracket either way. “If you’re a wise investor, it makes sense to take it all at once.”

Set Up a Trust

A smart move for lottery winners is to set up a trust. In states that permit it, creating a trust allows you to collect your winnings anonymously, which can avoid a lot of unsolicited attention from scammers and opportunistic long-lost friends and relatives. A well-designed trust can also allow for tax-free growth of assets, as well as reduce estate taxes for married couples.

Trusts are not just a good idea for lottery winners and the ultra-wealthy. Even families with a moderate income can reap the benefits from setting up a trust. For instance, trusts allow you to specify how and when your children inherit your estate, which can help them use their inheritance more wisely. You can also use trusts to provide funds for particular purposes, like for education and health care or to allocate monies for a favorite charity.

Pay Taxes Like a Millionaire

Sadly, lottery winners often end in financial ruin due to bad investment choices, greedy relatives and friends, misjudging the cost of taxes or the costs of maintaining the stuff they buy. This trap can be avoided by investing all winnings in a low-risk mutual fund and living off the interest. For example, if you invest a $250 million dollar windfall in bonds and a diversified mutual fund, you could easily generate $4 million a year after taxes.

Even investing a more modest $1 million lottery prize could earn you $50,000 a year, assuming your portfolio yields a 5% interest. Earning a living from your investments, as opposed to owning a business or working for a salary is the reason ultra-wealthy people like Mitt Romney and Warren Buffet pay a lower tax rate than their secretaries. Capital gains, or the money you generate from investing in stocks and bonds, is taxed differently than regular income. This is particularly true if you avoid the trap of trying to time the stock market and hold on to your shares and bonds for the long haul. As of 2013, the long-term capital gain tax rate is 15% for taxpayers with incomes in the 25% to 33% tax brackets.

Lottery as Voluntary Taxation

The words of John Fielding, the 18th century English satirist, hold true today.

A Lottery is a Taxation,
Upon all the Fools in Creation;
And Heav’n be prais’d,
It is easily rais’d,
Credulity’s always in Fashion;
For, Folly’s a Fund,
Will never lose Ground;
While Fools are so rife in the Nation

The quip that lotteries are a taxation on people who are bad at math is not a joke. According to The Tax Foundation, a non-partisan tax research group based in Washington, D.C., lotteries are not just a controversial way to fill state coffers, they are an actual tax. The use of lotteries to finance the government is nothing new. In 1892, A.R. Spofford, Librarian of Congress, described lotteries as the kind of voluntary tax the most reputable citizens would engage in — as part of their civic duty — to help with the financing of schools, hospitals and courthouses.

Today, lotteries have lost most of their patriotic component, although some lotteries are centered around charities, but they still are a significant component of state revenue. As with property taxes, lottery tax can be avoided altogether by refraining from buying a ticket.

Photo: pirateyjoe