Lotteries withhold 25% from the winnings just like an employer withholds a percentage of your wages in each pay period. Sometime in January, the employer gives the employees a W-2 form that states how much the wages were and how much was withheld for taxes. If somebody won $1 million they would get a W-2G form from the lottery stating they won that amount and $250,000 was withheld for taxes. The winner would fill out a form 1040 the same as they did the year before with the exception of line 21; "Other income (type and amount)". They would enter "gambling" for the type and $1 million for the amount and continue to fill out the form the same way they did the year before.
They get the same standard or itemized deductions, that amount is subtracted from the adjusted gross income, and they fill out a mini-worksheet to find out how much the tax is. If that amount is less than what was withheld, they get a refund and if that amount is more, they owe. As Todd said, the taxes are not exactly 35% (I added a $1 million to my 2007 return and it came out to 32%), but the winner should know they will owe at least another $75,000 in taxes.
"I sort of doubt it's like "income tax on money you earned from work."
On the 2007 form 1040 there are 17 lines for income, 8 lines on form 1040A, and the first line on both is for "Wages, salaries, tips, etc. from form W-2 we get from our employers. Believe it or not, there are other forms of income that is taxed exactly the same as your wages.
"People go to work, get a check and pay tax on their earnings, per check."
The amount the wages on that check are predetermined by the number of exemptions the employee has. A guy with a wife and 6 kids will have less in taxes withheld than a single person with no other exemptions. Some employers withhold a percentage in taxes for one weekly wage that is equal to the amount that weekly wage would make for an entire year. For instance that weeks wage could be much higher from working overtime and/or the weekend.
Look at it this way, winning $1 million in one year is the same adding all your weekly paychecks together for one year. If your wages are $41,600, you are taxed on the amount whether it was exactly $800 each week or 52 different amounts.
"So, if the IRS was to continue to tax his money, they would be taxing his "actual winnings that's sitting in the bank "untouched" -- that doesn't make sense."
The lotteries could withhold 35% and the winner would probably get a refund but since they don't, the winner should know they will owe more in taxes. They could put the entire check of $750,000 into an interest baring account. If they got 5% and the money was in the account for 6 months, the interest would be about $18,750. They would get a 1099-INT form from the bank, that amount would be put on line 8a as taxable interest income, and would be added to the gross adjusted income for the tax year. At a 32% tax rate, they would owe another $6000 in taxes on the interest too.
If the prize was won in 2007, it and whatever other income the winner had would be taxed for that year only. After paying whatever tax is owed, they would have at least $650,000 in tax free money. Whatever income they make from the $650,000 in 2008 will be taxed for that tax year. If they average a return of 7.5% from interests, dividends, stock sales, or any other type of investment on the $650,000, they would have an income of $48,750 for that year and would be taxed on that amount.
"I read about a lottery winner that did just that. He took his winnings and invested wisely through a team of financial advisors etc. His portfolio was set up where he live off the interests of his earning"
I've always wondered how that worked. Does this "team" spend weeks debating the "best" investment or do they just have one person find which of the company's funds best suits the investor based on the amount to be invested and the type of return?