As 2016 began, people were lining up to buy tickets for the Powerball lottery, which eventually reached a total prize of $1.58 billion. Many states have lotteries, and countless participants win prizes, albeit typically much smaller than the Powerball jackpot. Are such winnings taxable? The answer, in a word, is yes. (As an exception to this rule, some states exempt their lottery winnings from state income tax).
According to the IRS, lotteries are a form of gambling, along with raffles, horse racing, and casino games. Cash winnings are taxable income, as is the fair value of prizes such as cars and trips. All of your gambling winnings must be declared on IRS Form 1040 of your tax return as ’other income.’
Gambling winnings are taxed as ordinary income, with tax rates as high as 39.6 percent. Some large winnings, such as lottery payouts, can be spread over many years, which also spreads the tax bill. Taking a smaller amount in consecutive years may reduce the effective tax rate on those winnings.
How winnings are reported
Depending on the activity, gambling winnings of a certain size will be reported by the payer on IRS Form W-2G, which is sent to you as well as to the IRS. Larger winnings are subject to withholding, generally at a 25 percent federal rate; state tax also may be withheld.
Example: Lois Martin wins $10,000 in her state’s lottery. Of her winnings, $2,500 (25 percent) is withheld for the IRS while $500 (five percent) is withheld for her state. Thus, Lois receives $7,000 upfront. When Lois files her tax return for the year, her $10,000 lottery income, as well as the $2,500 and $500 amounts paid in tax, will be included in calculating her federal and state income tax obligation.
Gain from losses
Suppose, in this scenario, that Lois buys $10 worth of lottery tickets every week or $520 a year. Can she net that amount against her winnings to reduce the tax she will owe?
Not directly. The amount to be reported under ‘other income’ is the gross amount of your gambling winnings for the year. That includes all of your winnings, not just those reported on IRS Form W-2G. Note that this amount will be counted in your adjusted gross income (AGI), and an increased AGI may reduce your ability to use certain tax benefits elsewhere on your tax return.
To receive any tax benefit from her $520 in lottery purchases, Lois must itemize deductions on Schedule A of her IRS Form 1040. On this form, her lottery purchases can be included under ‘other miscellaneous deductions.’ Thus, Lois will reduce her taxable income from her lottery win and trim her tax bill.
The gambling losses that Lois can report on Schedule A are not limited to lottery purchases, even if her only winnings are from a lottery. She can report all of her losses from casinos, horse races, Super Bowl bets, and so on, up to the $10,000 she has reported as winnings. That is, the gambling losses you report on Schedule A of IRS Form 1040 can be no greater than the gambling winnings you report.
Suppose Lois has $11,000 in gambling losses for the year. She can deduct losses up to the amount of winnings she reports: $10,000 in this example. The excess $1,000 cannot be carried over to future years.
On the bright side, gambling losses are not subject to the various limitations on some miscellaneous itemized deductions.
Loss lessons
As is the case with any tax deduction, you will need evidence to support the amount of the gambling losses you claim, in case your return is questioned. Your best plan is to keep a detailed log of all gambling activities, showing winnings, and expenses, as well as tangible items such as lottery tickets and betting slips. Moreover, you should use gambling losses as tax deductions only if the total of all your itemized deductions exceeds the standard deduction you are entitled to claim.
If you need assistance from experienced tax professionals, we can help. Feel free to contact us today.