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Taxing mega lottery wins

The IRS requires all lottery agencies to withhold 24% of lottery winnings over $5,000 for federal taxes. On Jeanne’s $7.5 million purse, this amounts to $1.8 million.

But as lottery winnings are taxed as ordinary income, a windfall of this size would land Jeanne in the highest federal income tax bracket of 37%, meaning she must progressively pay additional tax until she meets the bracket’s threshold. In the end, her total federal tax bill will land at around $2.73 million.

The Buckeye State also taxes lottery winnings like normal income. Jeanne’s $7.5 million lump sum win would place her firmly in the top state income tax bracket of 3.5% for 2024, which would eat approximately $262,000 from her total.

After all that, Jeanne’s total tax liability related to her win alone comes to about $3 million — meaning she’ll only get to enjoy around $4.5 million from her $50 scratch-off win (which is still a stunning return-on-investment).

She has big plans for her winnings. Jeanne says she wants to pay off her best friend’s mortgage, whom she’s stayed with for the past two years, and she’d love to buy a house in Florida.

But could she have achieved those goals and collected more money in the long-run by taking the annuity prize option?

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What if she took the annuity?

If Jeanne took the $600,000 per year for 25 years, she would have received the full $15 million prize, eventually. Instead of feeling immediately wealthy, she would have been comfortably rich for years to come.

When a lottery winner chooses the annuity option, they typically pay taxes based on the annual payment (in this case, $600,000) rather than on the total prize amount.

So, Jeanne would be signing up to pay income taxes on $600,000 — plus any other income she earns through working, investments, benefits and so on — for two and a half decades. That would place her in the highest federal and state income tax brackets. However, Ohio Republicans in January proposed legislation that would gradually reduce and eventually eliminate state income tax by 2030.

In terms of federal taxes, she would owe around $180,000 on her winnings in 2024, and in state taxes, she would owe about $20,000. But these figures may change over the duration of the 25-year annuity if the federal income tax brackets are adjusted or the Ohio Republican bill passes. This also assumes Jeanne doesn’t reduce her tax liability through various clever strategies and with help from a financial adviser.

Annuity vs. lump sum debate

Once you get over the shock and elation of winning a life-changing windfall, there are many important things to consider. First, you typically have to choose between taking a lump sum or an annuity.

Many people take a lump sum because they want immediate access to the cash to buy big-ticket items like houses or cars — or perhaps, like Jeanne, they want to use it to pay off debts or to help friends and family.

With the lump sum, you also have the opportunity (after shelling out your taxes) to invest in growth-oriented assets like stocks, real estate and even alternative investments like precious metals, artwork and wine.

But there’s also a risk to choosing this option. Many people don’t have the financial infrastructure in place to deal with such a massive sum of cash and could end up making irresponsible money decisions.

With an annuitized payment, lottery winners can enjoy the security of steady income and peace of mind knowing they can’t blow through it all at once.

It can be worth working with a financial adviser on how to maximize that money stream. For example, you may want to put it to work via tax-advantaged investing accounts, like a 401(k) or a traditional or Roth individual retirement account. You can also consider making financial gifts and donations that will reduce your tax liability.

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If you don't survive the annuity period

One downside of the annuity option is that a winner may not live to see every payment over a 20-plus year period. What happens to the rest of their winnings in this case?

The remaining prize money goes to the winner’s estate or any named beneficiaries. If you wish to leave the money to any heirs, it’s key to have an estate plan in place so the lottery company may know where to direct future payments.

It’s also important to remember the deceased winner’s estate may be subject to federal and state estate taxes for the full value of future payments. If a winner dies shortly after winning a jackpot, there might not be enough cash on hand to pay Uncle Sam. A number of lottery companies in this case offer to convert an annuity into a lump sum payment, but only if permitted by the state. So, that’s one more thing to consider if you’re debating between an annuity or lump sum.

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Bethan Moorcraft is a reporter for Moneywise with experience in news editing and business reporting across international markets.

Disclaimer

The content provided on Moneywise is information to help users become financially literate. It is neither tax nor legal advice, is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Tax, investment and all other decisions should be made, as appropriate, only with guidance from a qualified professional. We make no representation or warranty of any kind, either express or implied, with respect to the data provided, the timeliness thereof, the results to be obtained by the use thereof or any other matter.