How To Minimize Taxes On Lottery Winnings—And Maximize Returns

Let’s say you just won the grand prize from your state’s lottery. How do you deal with that tax-wise? And get the most money out of your winnings? For answers, we asked Bruce Bell, an attorney at the Chicago office of Schoenberg Finkel Beederman Bell Glazer.

Larry Light: How do you handle this?

Bruce Bell: Lottery payments are subject to tax as ordinary income. While there is little you can do to avoid this income tax, there are steps you can take to minimize the tax burden.

Light: Like what?

Bell: First, figure out who the real winner of the lottery is. If friends or family members contributed to your lottery ticket purchases, you can establish a partnership arrangement as the lottery winners and may each pay lower taxes. Partnerships are not subject to federal income tax themselves. Any federal tax liability lands on the partners individually. The tax rate they pay is a different question, which we can cover in a moment.

The Internal Revenue Code requires such partnerships to be established in writing by the due date of the tax year, March 15 for calendar year partnerships, without regard for extensions. You also need to draw up a written partnership agreement naming who is in the group.

Light: How much tax liability are we talking about?

Bell: Federal income tax rates increase as income increases. But the income tax rates arising from partnership lottery winners may collectively be taxed at lower rates. The highest marginal income tax rate for a married couple filing a joint income tax return is 37% and that tax rate is reached at approximately $700,000 of taxable income. A partnership with multiple owners will allow more income to be taxed at lower tax brackets.

Light: What about state taxes?

Bell: Some don’t tax partnerships. But let’s say your state does and requires you and your fellow ticket holders to be taxed as a partnership. Then you might find it better to opt out of being a partnership for federal income tax purposes. You might up end up paying less. The point is, you have some flexibility.

Light: What about taking the lottery winnings in one lump sum payment versus in installments, payable over a period of years?

Bell: You’re better off going the installment route. Smaller payouts every year won’t be taxed as heavily as the whole amount at once. What’s more, you get less money, before tax, with a lump sum. The state lottery people give you more money if you opt to receive it over time.

Light: Lump sums also encourage people to blow the whole sum.

Bell: Yes, the installment option may serve as a safeguard from imprudently spending the entire winnings at one time. Lottery winners whose investment and personal needs are in excess of the first year’s annual payment may find that getting a bank loan to tide them over for the rest is easier than before they hit the jackpot: Lenders look favorably on people with guaranteed income streams, which defines installment lottery payouts.

Light: What other tactics are there?

Bell: Installment lottery winners can migrate to a different state with lower or perhaps no income tax. Currently nine states have none: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming. Barring some nuance of state law in the state where you hit the lotto, odds are your old state can’t claim a piece of your lottery winnings.