A lottery win means tax issues, as by federal law the IRS levies tax on all gambling and lottery income. How much you pay in tax depends on several variables, including where you live, what your individual tax rate is and whether you take the money in a lump sum or spread it out as an annuity. But the IRS is clear on one aspect of lotteries: You can't avoid the tax by transferring all or part of the money to a trust.
Lottery Income and Withholding
Any amount you win with a lottery entry is considered ordinary income by the Internal Revenue Service. You must include the full amount you receive in your gross income, which will later be reduced by exemptions, deductions and tax credits. The IRS requires that the lottery authority withhold 25 percent of your check and issue a Form W-2G to itemize the winnings. You declare the withholding as "taxes paid" on Form 1040, just as you would declare regular deductions from your paycheck. If you take the winnings as an annuity, then you declare the income as the money is received over the life of the annuity.
Trusts and Taxes
A trust is a financial entity that holds money and property in the name of the grantor and for the benefit of one or more beneficiaries on the death of the grantor. You set up a trust to protect your assets from a lengthy and expensive probate case, in which the courts determine how your property will be divided among your heirs. Trusts do not avoid federal estate taxes; and if you transfer lottery winnings to a trust, then that money may be taxed a second time if, upon your death, it exceeds the federal estate tax exemption of $5 million (in 2012).
Gifts and Charities
Once you've paid income tax on lottery winnings, you may want to gift a portion of the money to relatives or make donations to charity. Federal gift tax excludes $5.12 million of money you gift over your lifetime (as of 2012); for couples filing joint returns, the gift tax exclusion doubles to $10.24 million. Donations to charity are deductible in the year that you make them, up to half of your adjusted gross income.
Trusts and Lottery Management
Many big lottery winners set up trusts to receive and manage their money, and to keep some measure of anonymity. They may request that the winnings be paid out to the trust, rather than to them personally, to avoid the complications that sudden wealth might bring: claims on the money by friends, relatives and those who might file legal actions against them. A trust puts the money in the hands of a professional manager who takes on the responsibility of handling the account for the benefit of the winner. This arrangement, however, will not avoid federal or state income taxes on the winnings.
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