A house. A vacation. $1,000 a day for life. Who wouldn't want to win some expensive prize or the lottery? Actually, a lot of people – once they realize that these jackpots aren't free. Taxes – most prize winnings are taxed as income by the IRS – 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.

A House

After winning a home, 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. And, as with any prize, you'll be paying those taxes at your full marginal tax rate, because the value of the prize is reported it on your Form 1040 as "other" income, on top of any earnings 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.

Of course, if you can afford the tax bill, you're getting a home for the price of a generous down payment. But the costs of this type of prize don't end there. On top of income taxes, you'll also probably have higher recurring expenses in the shape of property taxes, homeowner's insurance, utility bills and general upkeep. You've gained a rich new asset, but you could end up being house poor.

A Car

After winning an auto, you'll once again be responsible for federal and state income taxes, based on the value of the vehicle; overall, you can estimate the authorities will collect about one-third of the value. This might not be so bad if you win a $15,000 Ford Fiesta (you get a brand new car by paying $5,000 to the IRS!), but if you win, say, a 2010 Porsche 911 Turbo Cabriolet, which retails for $143,000, you might not call yourself quite so lucky. And since cars given away as prizes are often luxury models, the new wheels could boost your income quite a bit, maybe even into a new bracket. You'll also have to pay registration and licensing fees.

Then there are the ongoing costs associated with auto ownership. You can bet that things like insurance premiums and maintenance are higher with a higher class of car: Oil changes on the cheapest Ferrari, for example, run around $500. And your shiny new 500-horsepower bullet probably doesn't get as good gas mileage than your current daily driver, either. (To learn more, see The True Cost Of Owning A Car.)

A Vacation

When you win a trip, you are taxed on the fair market value of the trip – and, depending on the sort of holidays you take, that might be as much as you'd normally spend on a vacation! Anything valued over $600 has to be reported on your tax return. As the winner, you'll be liable for taxes on the whole prize even if multiple people (like family members or friends) come along for the ride – unless you can get them to help out.

On the other hand, sometimes the fair market value is lower than you'd expect, because the sweepstakes sponsor was able to get a special deal or discount, which will make your tax bill seem like a bargain. So, while it won't be a completely free trip, it'll probably be a pretty opulent experience.

Plus, in many cases, you will still be expected to cover some expenses on this supposedly free trip. Say you enter a contest like one recently offered by Wall Street Journal Travel, in which the prize was a trip for two to Paris. It included airfare from New York to Paris, hotel and ground transportation and half a day of sightseeing. But if you didn't live in New York, you were responsible for travel expenses to get there, all your food costs (which will be sizeable), sightseeing, tips and all other spending money. Needless to say, these expenses could easily add up to the $4,200 the contest provider was shelling out.

A Dream Wedding

With most surveys pegging the average cost of a wedding at $20,000, it's no wonder that many couples scramble at the chance to score stylish nuptuals for free. But a contest-financed affair often comes with additional costs.

Take the upcoming wedding prize package recently offered by Harper's Bazaar. A "designer wedding" worth more than $33,000, it included a stay at a spa resort in Mexico. For example, the package came complete with a $2,000 engagement photo shoot in New York – but, as with the vacation above, transportation to and from New York wasn't provided. Bridesmaids' dresses and a designer wedding gown were included, but the cost of alterations wasn't. So, unless everyone was a perfect size 8 ….

To be fair, the contest paid for the key expenses, and the publication was very straightforward about what wasn't covered. Still, such items could really have added up for a cash-strapped couple (or their parents), and it's harder to budget when someone else is calling the shots.

Plus, for picky brides (and possibly grooms), a prize wedding can sometimes mean having the wedding the prize giver wants. The Harper's Bazaar package stipulated that the cake, decor and other details would be chosen by the contest sponsor. Accepting a prize wedding may make having a wedding your way next to impossible – and for many people, that's worth something too. (Want to plan (and pay) for your own wedding? Read Have A Princess Wedding On A Pauper Budget for tips.)

A Gambling Jackpot

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 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 (gambling winnings are generally subject to a flat 25% tax). The awarding entity may withhold the money up front and send it to the IRS on your behalf.

A Lottery

Playing the lottery counts as gambling. So should you win big, the proceeds will be considered gambling income, with all the implications detailed above: Payouts of jackpots over $5,000 automatically have 25% withheld for federal taxes. With some exceptions, states charge taxes too; depending on your state of residence, your total tax bill could be as high as 50%, based on your other income.

Other than that, there are no ongoing costs associated with winning the lottery, except for annual income taxes should you opt to take your winnings as an annuity. More on that below.

Options for Dealing with Prizes

So, now that you know the strings that come with a big win, what can do you do? With most prizes, you have five options:

  1. Keep the prize and pay the tax. This is the best option if you can afford the tax bill (and can use the prize, of course).
  2. 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.
  3. Receive a cash settlement instead of the prize. If you take money instead of a tangible object or amenity, at least you'll have the money to pay the tax that's due.
  4. Forfeit the prize. If the prize isn't worth the trouble to you, you can just refuse it.
  5. Donate the prize. In some cases, you can donate the prize to a government agency or tax-exempt charitable organization without paying tax on it.

Minimizing Lottery Jackpot Taxes

Obviously, winning the lottery is a tad different, and most of the above options don't quite apply. But you do have choices in handling the windfall.

The biggest one concerns how you'll actually get the money. As mentioned above, you'll have to decide whether to take the payment as a single lump sum or as an annuity – that is, annual payments, spread out over years (or decades). Each choice has its financial implications, and you may want to consult with a tax attorney, certified public accountant (CPA) and/or Certified Financial Planner (CFP) to discuss them before deciding.

But, strictly from a tax viewpoint, the annuity has some advantages. Let's say you win a $1 million jackpot. Today, if you take the lump sum, your total federal income taxes are estimated at $356,875 (figuring a tax bracket of 35%). Instead, let’s look at what happens if you take the million dollars as 20 payments of $50,000. Your total federal income taxes are estimated at $5,684 (or $113,680 after 20 years assuming that the tax rate doesn't change). You have saved $243,195 over the 20-year period.

Total Winnings

$1,000,000

$1,000,000

Payments

1

20

Paid Out in Year 1

$1,000,000

$50,000

Taxes in Year 1

$356,875

$5,684

Total Taxes Paid

$356,875

$113,680

Tax Savings

$0

$243,195

Winnings Received Over

20 Years

$643,125

$886,320

Other Lottery Considerations

The biggest way the lottery can be a burden is by wasting too much money on buying tickets in the first place. Face it: Your chance of winning a Powerball jackpot is about 292 million to 1. You’re more likely to be:

a. Killed by a vending machine: 1 in 112 million
b. Having identical quadruplets: 1 in 15 million
c. Becoming a movie star: 1 in 1.5 million
d. Dying in a plane crash or being stuck by lightning: 1 in 1 million
e. Dying in a car accident: 1 in 6,700

But if you're like most Americans (some 57%) who play regularly, your lottery ticket expenditures could amount to thousands or tens of thousands of dollars of lost investment income. Even a modest $5 a week lottery ticket budget adds up to $260 a year. After 20 years, even a conservative bond portfolio returning 3.8% would earn you over $7,500 (vs the $5,200 you would've spent on tickets). (See The Lottery: Is It Ever Worth Playing?)
Even if you did win the lottery, you might not be able to hold onto the money. One of the first things a lot of people do with their newfound financial freedom is to quit their job. It's also natural to go on a spending spree: a fancy new house, a new car and a luxury holiday. And then, maybe, help for friends, family, colleagues (everyone you've ever known will come out of the woodwork asking for aid). Drastically elevating expenditures, ceasing to earn income, gifts and handouts … small wonder that 70% of lottery winners eventually end up in financial difficulty.

To avoid that, you will want to assemble a team of experts that might include an attorney for any estate planning issues, a financial adviser, and a CPA or other tax specialist, as mentioned above, to help put a financial plan in place. Get the financial guidance you need, take the time to plan out what you want to do with your newfound wealth, and refrain from making rash decisions, economic and otherwise. Certainly, helping those close to you is good thing, but you need to set limits and you also must learn to say no.

Be Sure It's Legit

There's another way winning a prize can hurt you – if it's a scam. 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.
  • Bank information or a credit card number is never 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 on the item. 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.

The Bottom Line

Many people dream of winning a big prize in a lottery, contest or sweepstakes. The problem is, when the prize isn't cash, the tax burden and additional expenses associated with your winnings can really add up. Before you accept any prize, find out what it's worth – and what it will cost you – before you accept it. Remember that when you win something, you are responsible for paying taxes on it. Generally, you'll pay taxes in the year you receive the prize, which may not be the same year that you win the prize.

If you get a big cash windfall, from the lottery or another type of gambling, avoid the common mistakes: Don't do anything rash or go on a spending spree before you've hammered out an overall wealth management plan and done some long-term thinking and goal-setting. With lotteries, this includes determining how you want to receive the jackpot, which will impact how much you actually will get and when you will get it.

Before accepting any prize, consider the financial implications of keeping it and make a decision that will have the most positive impact on your long-term finances. Otherwise, your big win could turn into a losing proposition.

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