To say that lottery winnings are taxable oversimplifies a relatively complicated issue. Although the Internal Revenue Service says any income you earn or win is subject to taxes, it also offers a number of opportunities to let you reduce the portion of those winnings that are actually subject to tax.
Reporting on Lottery Winnings
If you receive substantial winnings from the lottery, you can expect to receive a W-2G form from the lottery. Similar to a W-2 from work, both the IRS and you get a copy of it, and it reports out how much you won. You will receive a W-2G if you win at least $600 and your winnings are at least 300 times the cost of your ticket. If you win less than this amount, the lottery will not report your winnings to the IRS. The W-2G will report your net winnings, so, if you spend $1 on a ticket that wins you $10,000, the W-2G will show winnings of $9,999. For smaller prizes, many lottery players pocket the cash from a ticket that pays $10 or $100. In fact, that income is still technically taxable, even though the IRS receives no report it.
Offsetting Winnings With Losses
Although your W-2G form will already have subtracted the cost of your winning ticket, you can deduct additional losses, as well, as long as you both itemize your deductions on Schedule A to your 1040 return and can document them. With this in mind, save your losing tickets and keep a win-loss diary. You can even write off any costs you incur in gambling. Your deduction will be capped at the total amount of your winnings, though. In other words, if you have $5000 in winnings, you can deduct no more than $5,000 in losses--just enough to zero out the winnings.
If you won a large prize, typically over $5,000, look carefully at your W-2G form. Odds are the lottery withheld 28 percent of your winnings as prepaid income tax. So, if your marginal tax rate is 28 percent or less, your withholding will likely cover your taxes, and you will not need to pay any extra on April 15. If you receive a very large prize, though, you may need to pay additional taxes above and beyond your withholding.
Do the Right Thing
There is one other way to reduce your taxes your lottery winnings; do the right thing. Instead of spending your windfall, save it. Depositing winnings into a tax-deferred savings plan such as an IRA or a 401(k) gives you a deduction equal to the amount that you deposit. If your winnings are less than the annual limit for these accounts, you can win the lottery tax-free.
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