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June 26, 2005 - What are the tax implications of winning a lottery?

How lottery winnings are taxed. First, you should be aware that your lottery winnings are taxable. This is the case for cash winnings and for the fair market value of any noncash prizes you may win, e.g., a car, vacation, etc. Depending on your other income and the amount of your winnings, your federal tax rate may be as high as 35%. Your lottery winnings may also be subject to state income tax. Thus, if you live in Colorado, your total tax bill could be near 40%.

On the other hand, you are entitled to a tax deduction for any gambling “losses” you had. These are taken as an itemized deduction but cannot exceed your winnings. If your lottery winnings are payable in annual installments, the installments you receive in future years are still gambling winnings, making losses in those future years deductible to the extent of the installments, even if you have no other gambling winnings in those years. Gambling losses aren't subject to any of the limitations on itemized deductions.

To establish your entitlement to a deduction for gambling losses, you should keep documentary evidence of the costs of your wagers—that is, the cost of your lottery tickets, but also of any other wagering you do, including betting on races, casino games, etc. The evidence should consist of receipts for tickets, wagers, cancelled checks, credit card charges, losing tickets, etc. Make sure you do this for all the years in which you're receiving installment payments of your lottery winnings. In some cases, taxpayer estimates have been allowed, but you shouldn't rely on this. Documentary evidence is preferable by far.

When lottery winnings are taxed. You report your lottery winnings as income in the year, or years, you actually or “constructively” receive those winnings. In the case of noncash prizes, this would be the year the prize is received. In the case of cash winnings, if you're required to take the winnings in annual installments, you only report each year's installment as income for that year. If you can choose between a lump-sum payment and a series of installment payments, when your winnings are taxable depends on when you made that choice. If, as is the case with many state lotteries, you had to make the choice when you bought the ticket, you include your winnings in income only when you actually receive them. In that case, if you chose the lump sum arrangement, you must include the entire lump sum in income in the year received. If you chose the installment arrangement, you must include the annual payments and any amount designated as interest on the unpaid installments in income as received.

Withholding. If you win more than $5,000 in the lottery, 25% must be withheld from your winnings for federal income tax purposes. You will receive a Form W-2G from the payor showing the amount of lottery winnings paid to you during the year and the amount of federal income tax withheld. This information also gets sent to the IRS by the payor. You must give the payor your Social Security number. If you fail to give the payor your social security number, 28% will be withheld. If state income tax withholding is required, the amount of state income tax withheld may also be shown on Form W-2G.

Estimated taxes. Since your federal tax rate can be as high as 35%, which is well above the 25% withheld, the amount of tax withheld from your lottery winnings may not be enough to cover your federal tax bill. If this is the case, you may have to make estimated tax payments in advance—and you may be assessed a penalty if you fail to do so. You may also owe state and local income taxes, and state and local estimated tax payments.

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