A lottery prize means federal income tax obligations
With the Tennessee Lottery to start in a week, participants might just be dreaming about a new house, a new car and traveling around the world. But it also means thinking about how playing the lottery can affect the filing of your federal income tax return.
Winning a lottery prize may open the door to many financial opportunities, but it may also result in a significant federal income tax obligation. Keeping good records of your winnings and losses may help you lower the taxes you owe on lottery winnings.
The following questions and answers provided by the Internal Revenue Service address some of the common federal tax considerations you may face if you play the lotto.
Q: Will my winnings be reported to the IRS?
A: You will receive your prize payment in one lump sum or in a number of periodic payments, depending on your election. The lottery commission will file a Form W2-G, Certain Gambling Winnings, if your total prize (whether paid in a lump sum or in installments) after subtracting your wager is at least $600 and at least 300 times the amount of your wager.
But even if your winnings are less than $600 and you do not receive a Form W-2G reporting your winnings, remember that all lottery winnings are reportable and taxable for federal tax purposes.
Q: Am I required to give my Social Security number?
A: If your winnings must be reported on Form W-2G, you must provide your taxpayer identification number to the lottery commission. If you fail to do so, the lottery must withhold 28 percent of your winnings as backup withholding if your winnings do not exceed $5,000. The backup withholding will be sent to the Internal Revenue Service and will be reported on your Form W-2G. If your winnings exceed $5,000, tax withholding is required whether or not you provide a taxpayer identification number.
Q: Will federal income tax be withheld on my winnings?
A: Your state lottery will withhold a required rate of federal income tax (25 percent under current law) from any prize payment that exceeds $5,000 and send it to the IRS. The Form W-2G reporting the total prize payment also will show the federal income tax withholding amount. You may need to make additional estimated tax payments if your tax rate will exceed the 25 percent that is withheld.
Q: What if the winning ticket is owned by several people?
A: The lottery commission usually will use information provided by the winners on Form 5754, Statement by Person(s) Receiving Gambling Winnings, to prepare Forms W-2G when the person claiming the winnings is not the actual winner or is a member of a group of two or more winners on the same winning ticket. The information about each winner and the division of the winnings provided on Form 5754 allows the lottery to issue a separate W-2G to each winner showing his or her share of the winnings and taxes withheld.
Q: How will I report the winnings on my federal tax return?
A: The total payment in Box 1 of Form W-2G should be reported on the "Other Income" line on your Form 1040, U.S. Individual Income Tax Return. Include the amount shown in Box 2 of Form W-2G on your Form 1040 as federal income tax withheld. If you file a paper tax return, you will attach at copy of Form W-2G to the return when you file it.
Q: Will I owe any more federal income tax on my winnings?
A: Whether you receive your prize in a lump sum payment or in periodic payments, the amount of withholding may not be sufficient to pay your federal income tax for that year. After receiving your payment you should estimate your total income and tax liability for the year using Form 1040-ES, Estimated Tax For Individuals, and consider making estimated tax payments, if necessary. This will ensure you will have your tax liability paid by the time you file your return and that you will not incur any penalties. For more information, see Publication 505, Tax Withholding and Estimated Tax.
Q: What happens if I sell my payments?
A: Some state lotteries allow you to sell future payments due from the lottery for a lump sum payment from a third-party purchaser. This lump sum payment represents the present value of the lottery prize payments sold. The lottery prize payments are gambling winnings, taxed as ordinary income. Therefore, the payment from the third-party purchaser is taxed as ordinary income. It should be reported on the "Other Income" line on your Form 1040. It cannot be treated as a sale of a capital asset.
You should estimate your total income and tax liability for the year you receive the lump sum payment. You may need to make estimated tax payments.
Q: What if I use my payments as collateral for a loan?
A: Some state lotteries may allow you to pledge some of your future payments as collateral for a loan. In this case, you will be signing a loan agreement, promissory note and/or security agreement. The loan proceeds are not taxable. However, the payment from the state lottery continues to be taxable, even if it is redirected to the secured creditor as a payment of loan principal and interest.
Q: What if I die before I collect all my lottery payments?
A: The rights to these future payments become part of your estate, and will be distributed to your heirs based on your will or other designation. The state lottery will make the payment to your estate or heirs, after withholding a portion for federal income tax. A Form W-2G will be issued to the estate or heir, and they will report the income on the "Other Income" line on Form 1041, U.S. Income Tax Return for Estates and Trusts, or Form 1040.
If the value of your right to future payments and other property is substantial, your estate may be required to file a Form 706, Federal Estate Tax Return, and pay a federal estate tax on the value of your overall estate. The heirs receiving your lottery payments may be entitled to deduct a portion of the estate tax as an itemized deduction on their tax returns in the years they report the lottery payment income.
Q: Can I deduct gambling losses on my federal tax return?
A: Gambling losses are considered Miscellaneous Itemized Deductions. They are deductible only up to the amount of the gambling winnings you report on Line 21 of Form 1040 and only if you qualify to itemize deductions. For 2003, gambling losses are entered on Schedule A (Form 1040), line 27.
Generally, you will qualify to itemize if your total Itemized Deductions (qualified medical/dental expenses, charitable contributions, real estate taxes, state and local income taxes, mortgage interest, casualty losses, and Miscellaneous Itemized Deductions) for 2003 exceed your Standard Deduction - $4,750 for single filers; $9,500 for married couples filing jointly; $7,000 for head of household.
Gambling losses are not subject to the adjusted gross income limitations that affect some Itemized Deductions nor do they have to exceed the 2 percent of adjusted gross income limit as do some Miscellaneous Itemized Deductions.
Q: Do lottery ticket expenses qualify as gambling losses?
A: Yes. They can be added to other gambling losses incurred during the tax year.
Q: What records should I keep to prove gambling winnings and losses?
A: You must keep source documents such as losing tickets, and you should document your gambling winnings and losses by keeping a diary or similar record of them. Your diary should contain at least the following information:
-The date and type of your specific wager or wagering activity,
-The name and address or location of the gambling establishment,
-The names of other persons present with you at the gambling establishment, and
-The amount(s) you won or lost.
For lotteries, you should keep unredeemed tickets, payment slips, and winnings statements to corroborate your diary entries.
Q: Where can I get more information about how gambling can affect my federal taxes?
A: Visit the IRS Web site (www.irs.gov) or call the IRS toll-free at (800) 829-1040. IRS Publications 525 and 529 include information on reporting gambling winnings and deducting gambling losses. IRS forms and publications can be downloaded from the IRS Web site or you can have them mailed to you by calling toll-free (800) 829-3676.