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5 tax tips for lottery winners

Powerball Update, Jan. 10, 2016:  There are some new millionaires in America this morning, including three Texans (one here in Austin, who, sad for me, is not me) who matched 5 of 6 Powerball numbers last night. But there was no Powerball big jackpot winner, so the drawing on Wednesday, Jan. 13, night will be for more than $1 billion for the first time. This morning it was $1.3 billion, with a cash lump sum payout of $806 million. This post applies to the latest winners, as well as the lucky person/people who win on Wednesday. 

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
~ Henry Fielding, 18th century English novelist, dramatist, satirist and magistrate

Pile of cash money by Nick Ares via FlickrPile of money photo by Nick Ares via Flickr

Yes, as Fielding wrote, lotteries are a form of taxation. In fact, they are the most voluntary of taxes.

Whereas we tend to rail at the Internal Revenue Service's collection of our taxes for Uncle Sam, millions of us happily hand over our cash to lottery ticket sellers in the hope of winning a huge pile of money.

Voluntary taxes for state services: To sooth our guilt and embarrassment for wasting money, albeit usually just a few dollars -- and, yes, as long-time readers know, I also play the lottery when the jackpot gets huge, like the current $900 million $1.3 billion and growing Powerball, which is this week's By the Numbers figure --  we remind ourselves that our lottery buying helps support, in most cases, state education programs.

The latest U.S. Census look at lotteries, examining 2012-2013 data and released in February 2015, shows that state lottery ticket sales increased almost 5 percent in 2013, from more than $59 billion in 2012 to $62.4 billion in 2013. Makes you wonder why public schools nationwide aren't better, but I digress.

And for the lucky few who win, lotteries are boon to the U.S. and most state treasuries thanks to the income taxes that are due on gambling winnings.

A handful of states, like my home of Texas, don't collect any income tax; others have special tax rules for lottery winnings. But regardless of the winner's state tax residency, he or she will owe federal income taxes on the Powerball payout.

Since you'll probably be freaking out a bit lot when you realize you picked the winning numbers, here in advance of all the shouting and jumping up and down are 5 quick tax tips for dealing with your new wealth.

1. Hire or at least consult a tax professional.
A tax pro will be able to give you an overview of the myriad tax issues you'll face at the federal and your state and local levels. It's a good dose of reality during this surreal time. And while this is the shortest of the five tips, your trusted tax expert will play a crucial role in helping you work through the rest of the things that a sudden millionaire must think about.

2. Decide how you want your money.
The smart-ass answer is "as soon as possible." But that's not the smart answer.

Depending on where you live you'll have time, possibly months, to decide whether to get your winnings at once in a lump sum ($558 million $806 million as I type) or as 30 annuity payments over 29 years (the first payment is immediate). Your tax pro can help you break out the tax costs of the choices.

The advantage of taking a lump sum is you get all the money at once. The disadvantage of taking a lump sum is that you must pay tax on the entire amount in one tax year.

You also need to do a little economic and political prognosticating. The current top federal individual ordinary income tax rate is 39.6 percent. Plus there's the 3.8 percent net investment income tax that's tacked on to earnings by wealthy taxpayers, of which you'll be a part. If you think the top U.S. tax rate or your state's taxes might go higher after the 2016 election, it could affect your decision.

The advantage of an annuity is that you're taxed only as you receive the payments. The disadvantage of an annuity is you only get a few million a year.

You also don't have any control over how the winnings might grow. Compare the effective yield of the annuity with what you could earn by taking the money at once, paying the taxes and then investing the proceeds on your own.

Or not on your own. Which brings us to tip #3.

3. Pick a team of financial and legal advisers.
Regardless of how you take the winnings, you're probably going to be in the highest tax bracket for a while. Your tax pro, as well as an investment adviser, accountant and attorney can help you sort through the financial and legal intricacies of dealing with such a large amount of money.

There are ways to legally shelter your income. But they are complex. That's why the rich hire the best and brightest advisers to maneuver through the financial and tax rules and regulations.

Also note that there are some investment-related expenses that you may be able to deduct. Sure, they're miscellaneous itemized deductions, meaning they're subject to the 2 percent of adjusted gross income threshold. Given your new net worth and how well your investments do, that's a percentage you're not likely to reach.

But just in case -- and for folks who don't hit the jackpot tonight on Wednesday -- here are some miscellaneous investment-related deductible expenses:

  • Fees for investment counsel and advice, including subscriptions to financial publications
  • IRA or Keogh custodial fees, if paid by cash outside the account
  • Software or online services you use to manage your investments
  • Safe deposit box rent, if you use the box to store certificates or investment-related documents
  • Transportation to your broker’s or investment adviser’s office
  • Attorney, accounting or clerical costs necessary to produce or collect taxable income
  • Charges for automatic investment services and dividend reinvestment plans
  • Costs to replace lost security certificates

4. Carefully consider gifts.
With all that new disposable income, you'll probably want to share the wealth. This includes with charities as well as with friends and family.

If you want to give to your favorite IRS-approved nonprofit, talk with the charity first. While it will definitely be grateful for the financial help, getting a huge gift also could pose some planning issues for the organization.

Don't just show up with a big check. Work with the group, again through your financial advice team, to set up a giving strategy that helps the charity and does your financial and tax plan some good, too. A better move might be setting up an endowment fund that makes an annual payment to that charity.

As for your family and friends, make sure you know what effect such a gift could have on them and you. True, gifts are never taxable to the recipient, but when you give more than the annual gift exclusion amount -- which is $14,000 this year -- then you have some tax paperwork to complete.

Also, note that an extravagant gift, however well-intentioned, could have additional financial obligations that the recipient isn't prepared to meet.

An expensive car means higher auto insurance costs. A high-dollar home also will have more operating and maintenance costs, as well as an equally high property tax rate that the new homeowner might not be able to meet year after year.

And don't forget the ultimate gift: bequests to heirs. Again, your financial dream team can help you work through the considerations of what will happen to your money once you're gone.

The 2016 federal estate tax exemption is $5.45 million per individual; it's adjusted annually for inflation, so by the time this is a consideration, more of your estate will be free from the 40 percent federal estate tax. A handful of states also collect an estate tax.

5. Tally your gambling losses.
OK, it's early in 2016 and unless you have a major gambling problem you probably don't have many gambling losses yet.

Powerball no 010916 winner_now 1-point-3 billion jackpot 011016 And realistically, if your Powerball numbers come up tonight next Wednesday, Jan. 13, you'll never accumulate enough in losing bets to make a dent in your taxes due on the jackpot.

But for the rest of us casual gamblers who occasionally drop a few dollars on lottery tickets or other games of chance, our relatively meager winnings might be offset by our many more gambling losses.

The key, as with all things tax, is to keep track of your gambling wins and losses throughout the year. You losses can offset your winnings, but not create a gambling loss.

For most of us tonight next week, our Powerball tickets will go into our gambling loss folder. But you never know.

Good luck!

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