Mega Millions, Mega Taxes

After hoards of hopefuls braved lines at sketchy convenience stores with dreams of becoming millionaires, an ultra-fortunate three scored the ultimate prize. Friday’s record-breaking $656 Mega Millions jackpot is going to be divvied up among a trio of lucky winners in Maryland, Kansas and Illinois — which works out to about $157.9 million as a lump sum for each winner.

But as we all know, mo’ money, mo’ taxes. And how much mo’, exactly? We hit up the big brains in The Tax Institute to find out. We asked Principal Tax Research Analyst Gil Charney a few questions about the tricky business of becoming mega-wealthy overnight.

Assuming each of the three winners elects to get their winnings in one lump sum, how will it be taxed? What will each of the winners take home after taxes? Is it considered income?

Yes, the lottery winnings are taxable as ordinary income, per Internal Revenue Code §61. Income is included in “gross income,” which the Code defines as “all income from whatever source derived,” except that which is excluded – and gambling winnings are not excludable. Regardless of the taxpayer’s marginal tax bracket before the winnings, he or she will be in the top bracket (35%) when considering the winnings.

Below is a set of assumptions to arrive at a tax amount for these winnings:

  • Taxpayer is single with no dependents, has no other income, and itemizes only for the state taxes withheld on the winnings ($11 million, as noted below)
  • A pre-tax lump sum payment of $157.9 million is received in 2012 (for one of the three winning tickets)
  • Federal tax withholding will be 25%, or $39,475,000
  • Assuming a state tax withholding rate of 7%, an additional will be an additional $11 million, for a total withholding (federal + state) of $50.5 million. Actual state withholding requirements vary depending on the state.
  • A winner would take home $107.4 million after taxes.
  • The winner claims an itemized deduction of $11 million in state tax withholding.
  • The federal tax liability in this case will be $51 million (leaving the taxpayer with a balance due of approximately $11.5 million). This assumes no additional interest or investment income from the winnings. Actual state taxes will vary. Note that we are talking about tax liability, not tax withholding.

Got it. Do you think they should they take the lump sum payout, or go for the annuity payments?

Each winner will need to look at his or her own situation to determine what the best option is for that person. Age and health would likely enter into such a decision. For example, taking a lump sum may be preferable if the person is ill, or whose life expectancy is not great. Granted, winning hundreds of millions of dollars is an incredible amount, but twenty-six years is a long time. Taking a lump sum will allow the winner to maximize contributions to a trust that will become a legacy for surviving family members, charitable organizations, etc. Also, because of the duration of the annuity period, no one can predict tax rates, so taking a lump sum now “fixes” the tax liability. With a top rate of 35% actually quite low historically, a case can be made for taking the lump sum now.

As for the annuity option, no matter how you slice it, the annual payments will be more than the winner could have dreamed of. Many people are tempted to spend large sums of newfound money, so by annuitizing the payout, the future earnings are protected. If you “blow” the first annuity payment of $8.4 million ($218.7 million ÷ 26 annual payouts, including year 1), you still have many more years to regain your balance. Diversification over time, like diversification in investments, spreads risk so that a bad decision with a single, lump sum amount can be minimized or avoided.

What if a winner gives away some of the winnings to family?

The only way the winner can avoid tax liability is to disclaim the winnings – not taking possession of the winnings or claiming the amount. Giving winnings away to family (and friends) has no income tax effect – the winner is still responsible for paying taxes as described above. However, any gift that exceeds $13,000 in 2012 would require the winner to file a gift tax return (Form 709), and with winnings of this size, he or she may be liable for gift taxes as well. Winners may wish to consult an attorney who specializes in estate planning before making any large gifts.

What happens if a winner gives away the winnings (or a portion of the winnings) to charity?

Even if the winner were to direct the full winnings to qualified charitable organizations, the winnings would be taxed because he or she has decision-making authority on the timing, amount, and organizations for such contributions. Only by fully disclaiming the winnings, and walking away from the money, can the tax be avoided. While contributions to qualified charitable organizations can be deducted on the federal tax return, there are limits on the deduction for charitable contributions. One limit for a taxpayer who does contribute some or all of the winnings allows the taxpayer to deduct his or her contribution up to the extent of 50% of AGI, with the remainder carried forward for up to 5 years, with any remaining contribution lost forever.

This does present the opportunity for the winner to set up charitable lead trusts (CLTs), charitable remainder trusts (CRTs), or another types of charitable trusts. With a CLT, the trust pays a specified amount to a designated charity (or charities) each year for a specified number of years (the charitable term), with the remaining assets distributed to non-charitable beneficiaries at the end of the charitable term.

With a CRT, the winner (grantor who creates the trust) provides that one or more other individuals (not charities) receive a certain amount each year for a specified term, and at the end of this term, the remaining trust assets pass to a charitable organization (or organizations).

What advice do you have for the winners? (Are you listening, people?)

  • Don’t make rash decisions – sign the ticket and put it in a safety deposit box. Try to avoid publicity as much as possible. All kinds of charitable organizations, solicitors, and friends the winner never knew he or she had will come out of the woodwork. Some requests will be legitimate and honorable, and many more will not.
  • Form an advisor team ASAP consisting of one or more good tax advisers and financial planners. Decisions that will have to be made include:
    • Taking the lump sum option or the annuity method.
    • Investment decisions – even if the annuity method is selected, how and where to invest the payout.
    • Charitable decisions – how much and to what organizations can be donated, consistent with the winner’s values and objectives.
    • Trusts – the tax attorneys on the team can create specific trusts to accomplish the winner’s tax and estate planning goals. The trusts can be designed to protect the principal and ensure that the earnings from the trust are used in accordance with the trust documents.
    • Tax planners to project the tax impact of all of the above decisions, and to provide input to the advisers on what decisions will minimize the tax bite to the extent the decision is consistent with other objectives.
  • Budget an amount for spending, and leave the rest until a plan is developed with the advisers. For example, it’s easy for someone to want to go out and buy new homes, new cars, etc. To a certain degree, that’s a natural reaction to winning such a large sum of money, and should not be unnaturally and totally suppressed – instead, it should be controlled.

There you have it, lottery winners: welcome to a new tax bracket – and good luck with those big decisions. Please try to keep the yacht purchases under control.

[Image: Jennuine Captures via Flickr]

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