How are lottery winnings taxed?

While we are all sadly aware that lottery winnings are subject to taxes - the next question is how? And how much? You can win just about any amount in a lottery, but then it's best you know how taxes are charged in order to avoid surprises. Yes, surprises, because many who win a certain big amount from the lottery are quick to conclude they'll either get to own the entirety of the win or just pay a token of the winnings in tax. Imagine the utter shock when they realize not only is the tax higher than they imagined, but state and local government tax is also due. Are state and local government taxes on wins different from the federal tax? The simple answer is yes. 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 to 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. 

Reporting 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. 

Tax rates on 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. 

Lottery winnings tax brackets

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.

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.

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