Lottery Winners Can Be BIG Losers!

March 16, 2015
Lottery Winners Can Be BIG Losers!
Larry Warner Jr.

Occasionally we encounter clients that hit it big at the casino, win the lottery or perhaps even a sweepstakes.  Often times, in their excitement of winning, they begin spending their fortune on items they normally would not buy.  It was unexpected money so why not have fun with it, correct?  Unfortunately taxes are rarely given a thought .  Perhaps this is because the payer of the winnings often withholds tax and the winner thinks their tax burden has been taken care of.  What they often find out, and usually too late, is that the tax withheld is often nowhere near enough on big winnings.  Below is an example of not so fortunate taxpayer:

Lucky Larry bought a lottery ticket and hit it big with a $ 1,000,000 jackpot.  The lottery commission withheld 25% federal tax and 3% state tax.  Larry received a net check of $ 720,000 and commenced to spending.  He showered his relatives and friends with gifts and bought himself a nice new boat.  He even ran out of toys to buy so he donated the remainder to his favorite charity-the only smart thing Larry did with his winnings!  In January of the next year, Larry received a tax form in the mail that showed his $ 1,000,000 in winnings and the taxes withheld.  He took this form to his CPA along with his other documents as normal for tax preparation.  The CPA congratulated Larry on his winnings and asked him how much he saved for taxes.  Larry thought the CPA was joking since plenty of tax had been withheld on the winnings.  The CPA explained that the highest federal tax bracket is 39.6% which is quite a bit more than the 25% tax that the lottery commission withheld and that Larry could potentially owe $ 146,000 in federal tax.  When Larry was finally able to breathe, he realized that he would be selling his boat and obtaining a loan to pay his taxes.  If only he had consulted his CPA before shopping!

The CPA comforted poor Larry somewhat by telling him that he could deduct all the losing lottery tickets and other gambling losses he incurred during the year to reduce the taxability of the winnings.  He also confirmed that Larry would benefit from the charitable contribution he made since that would also help offset the winnings.  But neither of those items would help with the state tax owed.  The CPA explained that it would have been wise for Larry to pay the anticipated additional state tax that would be owed on the winnings prior to December 31st of the winning year so he could receive a federal deduction for it which would also lower the tax.  Too late for lucky Larry to take advantage of this strategy now the CPA explained.  Oh poor Larry (literally poor).

So the moral of the story is if you know someone that is “lucky” make sure they consider the unlucky side of taxes associated with their winnings.  There are ways to mitigate and plan for the tax hit of being lucky but it takes a conversation with your CPA to keep as much as possible of your winnings in your pocket.