Can you afford to win an expensive prize? Many people don't realize that some prizes aren't free. Taxes and the ongoing costs of ownership can quickly turn some windfalls into major burdens. What follows is an analysis of some common prizes we'd all like to win and how much it can cost to win them.
After winning a house, you'll be responsible for federal income tax based on the value of the home and perhaps state income tax depending on your state of residence. After winning any prize, you'll be paying taxes at your marginal tax rate because the value of the prize is on top of any income you've earned from employment and investments. For a $100,000 home, your federal tax bill alone might be roughly $25,000. Unless you already own a house that you plan to sell, many people can't afford to pay that kind of money all at once, even with several months of notice. Furthermore, consider that most prizes in the form of dream homes can often be worth more than $500,000 and are located in a high cost of living area.
If you can afford the tax bill, you're getting a home for the price of a generous down payment. On top of income taxes, you'll also have recurring costs like higher property taxes, homeowner's insurance, utility bills and maintenance. You may also want new furnishings for the new home.
After winning a new car, you'll once again be responsible for federal and state income tax bills based on the value of the vehicle. You'll also have to pay registration and licensing fees. The vehicles given away as prizes are often luxury vehicles, which can mean income tax burdens that are as pricey as a more modest new car. Then there are the ongoing costs associated with maintaining a new car, such as higher insurance and maintaining the physical appearance of the car. In theory, your maintenance costs will decrease if your new car is under warranty, but the new car could end up being a lemon or may be less reliable than your old car.
When you win a vacation that does not include lodging, you'll most likely choose to stay in a modest hotel, but the taxes you could end up paying on the fair market value of the trip might be as much as you'd normally spend on a vacation. You may not necessarily get a free vacation, but you will get an opulent vacation at an inexpensive price. Sometimes the fair market value of a vacation package is lower than you'd expect because the sweepstakes sponsor was able to get a special price, which will make your tax bill seem like a bargain.
You'll pay taxes on the whole prize even if multiple people benefit from the vacation. If the amount of tax you have to pay on your winning vacation isn't worth it to you, consider forfeiting the prize. If it is, maybe you can convince the friends you've invited along to help out with the tax burden.
Uncle Sam wants to encourage the money-wasting habit of gambling because the tax bill on any money you win from gambling can be offset by any money you have lost. However, you'll only get this benefit if you itemize your taxes rather than taking the standard deduction and you can't deduct more than the amount you have won. Winnings from lotteries, horse races, betting and casinos are all considered gambling income by the Internal Revenue Service (IRS). If your win is high enough, you may have to pay an estimated tax at the time you receive the prize. The awarding entity may also withhold the money and send it to the IRS on your behalf. The IRS is specific about how to deal with your gambling winnings. For more details, consult the IRS index of winnings.
After winning the lottery, you'll have to decide whether to take the payment as a lump sum or an annuity. You may want to consult with a tax attorney, certified public accountant (CPA) and/or Certified Financial Planner (CFP) to discuss the financial implications of each choice before deciding. Depending on your state of residence, your tax could be as high as 50% based on your other income and winnings.
Unless you hire a financial planner, there are no ongoing costs associated with winning the lottery. However, if you drastically elevate your spending habits to an unsustainable level, winning the lottery can become detrimental to your long-term financial health if your funds run out and you can no longer afford your new lifestyle.
The biggest way the lottery can be a burden for the average person is by wasting too much money on buying tickets in the first place, as the odds of winning are so incredibly low.
SEE: The Lottery: Is It Ever Worth Playing?
With most prizes, you have five options:
- Keep the prize and pay the tax. This is the best option if you like the prize and can afford the tax bill.
- Sell the prize and pay tax on the proceeds. If you don't want the prize or if you can't or don't want to pay the taxes on it, you can still benefit from your win by selling the prize.
- Receive a cash settlement instead of the prize. If you win cash instead of an object, you won't have any problems paying the tax that's due.
- Forfeit the prize. If the prize isn't worth the trouble to you, you can just refuse it.
- Donate the prize. In some cases, you can donate the prize to a governmental unit or tax-exempt charitable organization without paying tax on it.
There are a many things to be wary of when winning a prize. Here are some things that all legitimate prizes have in common:
- You never have to pay any money to enter a sweepstakes or shipping and handling charges if you win the prize.
- Bank information or a credit card number is not necessary to claim your prize.
The following are red flags that should alert you that a contest may be fraudulent:
- Receiving a phone call or letter stating that you have won a prize when you don't recall entering any sweepstakes.
- Getting a tax form that has an inflated approximate retail value compared to its fair market value. You are required to pay taxes on the fair market value of the prize.
- The organization offering the prize tries to talk you into taking advantage of dubious tax loopholes in order to convince you to claim the prize even though you may not be able to afford the tax.
Remember that you are responsible for paying taxes on the prize. Any time you win a prize, you'll pay taxes in the year you receive the prize, which may not be the same year that you win the prize. Before accepting a prize that you've won, consider the financial implications of keeping it, make the decision that will have the most positive impact on your long-term finances.