Winning the Lottery: Dream or Nightmare?

A house. A vacation. A thousand dollars a day for life. Who wouldn't want to win a huge prize or the lottery? Actually, a lot of people—once they realize these jackpots aren't free, because most prize winnings are taxed as income by the Internal Revenue Service (IRS).

Taxes and the ongoing costs of ownership can quickly turn some windfalls into major burdens. Below are some common prizes we've all dreamed of winning and how much it costs to keep them.

Key Takeaways

  • You are taxed on anything you win, whether it's cash, an item, a trip, or a service.
  • Winnings are subject to federal and state income taxes.
  • Most tangible prizes like cars and homes are taxed at their fair market value.
  • Lottery winnings are taxed for the year in which they are collected, allowing winners who choose annuities to spread the tax bill.
  • If you win a house, boat, or car, prepare to pay for their upkeep.

The Cost of Winning a House

After winning a home, you'll be responsible for paying the federal income tax based on the home's value. You may also be liable for state income tax, depending on your state of residence. As with any prize, the home's fair market value must be reported on Form 1040 as other income, and will be taxed at your marginal income tax rate.

Unless they already own a home they plan to sell, many people couldn't afford to pay such a significant sum all at once, even with several months' notice. Furthermore, consider that homes given away as prizes are worth more than $500,000 and located in expensive areas.

Of course, if you could afford the tax bill, you'd be getting a home for the price of a generous down payment. But your costs wouldn't end there. On top of income taxes, you would also have higher recurring expenses such as property taxes, homeowner's insurance, and utility bills, not to mention the cost of general maintenance and upkeep. Despite striking it rich in the sweepstakes, you could end up house poor in the end.

You must report any and all of your winnings to the IRS regardless of their value.

A Brand New Car

Just as with that prize of a home, you'll be responsible for federal and state income taxes on any cars you win. These too will be based on the vehicle's fair market value—the combined federal and state bill might add up to about one-third of the car's value.

This may 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 a sports car that retails for over $100,000, the tax bill would be proportionately higher. Since the cars that are given away as prizes are often luxury models, the new wheels could boost your reported taxable income quite a bit, maybe even into a new bracket taxed at a higher marginal rate.

Don't forget that you'll have to pay registration and licensing fees in order to get that car on the road. Then there are the ongoing costs associated with auto ownership. You can bet things like insurance premiums and maintenance are higher for a more expensive car. Oil changes on the cheapest Ferrari are pricey. And your shiny new 500-horsepower bullet probably doesn't get gas mileage as good as your previous ride's.

A Vacation

When you win a trip, you are taxed on its fair market value. Depending on the sort of holidays you take, the taxes might be as much as you'd normally spend on an entire vacation. As the winner, you'll be liable for taxes on the whole prize even if others come along—unless you can get them to pitch in. 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 could lower your tax bill.

In many cases, you will still be expected to cover some trip expenses. Say you enter a contest in which the prize is a trip for two to Paris. It includes airfare from New York to Paris, hotel, ground transportation, and half a day of sightseeing. But if you don't live in New York, you are responsible for travel expenses to get there, all your food costs, sightseeing, tips, and other spending. Needless to say, these expenses could easily match the value of the prize.

A Dream Wedding

According to the 2021 Brides and Investopedia wedding survey, the average wedding budget is about $20,000, so it is no wonder many couples jump at the chance to win a stylish wedding at the prize sponsor's expense.

However, there are often additional costs. For example, say a wedding prize package offering a "designer wedding" worth more than $30,000 includes a stay at a spa resort in Mexico and an engagement photoshoot in New York. Transportation may be covered only to Mexico, however. Bridesmaids' dresses and a designer wedding gown were included, but costs for alterations weren't.

Even if crucial parts of the trip are covered and the contest is explicit about what's not included, it may not be a good deal. Such items can add up for a cash-strapped couple (or their parents), and it's harder to budget when someone else is calling the shots.

A prize wedding can sometimes mean having the wedding the prize sponsor wants instead of the one the couple dream of. The contest organizer may choose the cake, the decor, and other details. Accepting a prize wedding may make having a wedding your way next to impossible—and for many people that could be a deal-breaker.

Gambling Winnings

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 in the same year. Winnings from horse races, sports betting, and casinos are all considered gambling income by the IRS and must be reported as such on your return.

Depending on the game and the amount you win, you may have to fill out a payer-provided Form W-2G when you receive the prize, from which a standard rate of 24% of your winnings will be withheld and sent to the IRS on your behalf.

The Lottery

Playing the lottery counts as gambling. So if you win big, the proceeds will be considered gambling income, with all the implications detailed above. Payouts of jackpots over $5,000 net of the wager automatically have 24% withheld for federal taxes.

Most states tax lottery winnings as well; depending on where you live your total tax bill could be as high as 50% of the prize based on your other income. In contrast to a house or a car, there are no unavoidable ongoing costs associated with winning the lottery. That is except, of course, for annual income taxes owed should you opt to receive your prize as an annuity–more on that below.

$1.586 billion

The value of the largest lottery jackpot in the world as of July 2022, split between three Powerball tickets in January 2016.

Options for Dealing With Prizes

Now that you know the strings attached to a big win, what can 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.
  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 (annual payments spread out over years or decades). Each choice has financial implications, and you may want to consult with a tax attorney, certified public accountant (CPA), or certified financial planner (CFP) to discuss them before deciding.

Strictly from a tax viewpoint, the annuity has some advantages. Let's say you win a jackpot with a $1 million lump-sum payout. (Jackpot amounts are advertised based on the cumulative annuity payments winners would receive, and the lump-sum payout is usually significantly smaller.)

If you took the lump sum, you would owe $370,000 in federal income tax based on the top marginal tax rate of 37%. If you opted instead for an annuity paying $50,000 a year, you might only be taxed at a 22% marginal rate, paying $11,000 per year or $220,000 cumulatively over 20 years on the first $1 million of annuity payments.

By limiting the rate at which your winnings are taxed, the annuity would have saved you $150,000 in taxes on that first $1 million in lottery winnings.

Gross Winnings
Paid After 20 Years
 $1,000,000  $1,000,000
Payments 1 20
Paid Out in Year 1  $1,000,000  $50,000
Taxes in Year 1 $370,000 $11,000 
Total Taxes Paid  $370,000 $220,000
Tax Savings $0 $150,000 
Net Winnings
Received Over 20 Years
$630,000 $780,000

Other Odds to Consider

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 after receiving their newfound financial freedom is quit their job. It's also natural to go on a spending spree: a fancy second house, a new car, a luxury vacation. And then, maybe, help friends, family, colleagues—you might be surprised by the number of people asking for money. Between the usual decision to forego earned income, the increased spending, the requests for gifts, and the ever-present hazard of scams targeting newfound wealth, it's no wonder so many lottery winners eventually end up in financial distress.

To avoid such pitfalls, you will want to assemble a team of experts that may include an attorney for estate planning issues, a financial advisor, and a CPA or another tax specialist to help put a financial plan in place. Get the financial guidance you need, take the time to plan what you will with your good fortune, and refrain from making rash decisions—economic or otherwise. Certainly, helping those close to you is a good thing, but you need to set limits and learn to say no.

Lottery and sweepstakes scams are a common type of fraud reported to the Federal Trade Commission (FTC).

Be Sure It's Legit

There's another way that winning a prize can hurt you: If it's a scam. Here are some things all legitimate prizes have in common:

  • You never have to pay any money to enter sweepstakes, or to pay shipping and handling charges if you win.
  • Bank information or a credit card number are never necessary to claim your prize.

The following are red flags indicating that a contest may be fraudulent:

  • Receiving a phone call or letter stating you have won a prize when you don't recall entering any sweepstakes.
  • Getting a tax form with 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.

What Are My Chances of Winning a Lottery Jackpot?

The chances of winning the top prize in the most popular lottery games with the highest jackpots are pretty slim. For example, in 2022, the odds of winning all or a share of a Powerball jackpot were 1 in 292.2 million.

How Much Are the Taxes on Lottery Winnings?

The taxes owed on lottery winnings depend on a few variables, such as the amount of the win, whether you take the money in a lump sum or as an annuity, and your state of residence. Lottery winnings are taxed as ordinary income by the IRS and most states. The exceptions are the states without an income tax along with Californoia and Delaware, which do not tax state lottery winnings.

Do You Owe Taxes on Prizes?

Yes. If you win a vacation, home, boat, or car, you will be taxed on the fair market value of those prizes.

What Happens If I Win Powerball?

If you are lucky enough to win a Powerball jackpot, you will have to meet with lottery officials and provide the winning ticket for verification. If you are wise, you will also speak with a financial advisor about the best way to collect your winnings⁠—as a lump sum or in annual installments.

The Bottom Line

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

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

Before accepting any prize, consider the financial implications of keeping it and decide if it will improve your financial situation in the long run. Otherwise, your big win could turn into a losing proposition.

Article Sources
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