Imagine you win a large lottery jackpot. Untold and unexpected millions will cascade down upon you. You show up at a news conference and a reporter asks the question, “What are you going to do with your winnings?”

A smart financial plan should focus on tax considerations long before you ever show up at Lottery Headquarters to cash your winning ticket.

You are a generous giving person and you want to look good when the cameras are rolling at your news conference (It might not have been a bad idea to shun the limelight and opt for privacy).

So you answer: “I’m going to quit my job, pay off all my debts, and put money aside for my children’s (or grandchildren’s) college education. I plan to share the bulk of my winnings with my family members and give a substantial amount to charity. I feel so fortunate.”

An altruistic answer indeed, but one filled with traps for the unwary. If I were an IRS agent I’d be salivating. If the winner actually goes through with his stated plan he would be subject to a horrendous tax bite and could end up with nothing. It’s an imperative to consult with a qualified financial adviser, your attorney, and a sharp CPA.

The first decision is whether to take your winnings as an annuity or lump sum. It is rare a lottery winner would have the experience of handling this much money, thrust upon them all at once. For that reason many financial advisers tell winners to take the money over many years so they can’t blow it at once on a number of bad investments or be defrauded by unscrupulous bloodsuckers. The strategy of receiving the money over time could help save the winner from himself. The temptation to spend it all on fast cars, large houses or other extravagances can be forestalled.

However, there is something to be said about taking a lump sum payout. Because of today’s low interest rate environment these payouts are unusually high. For this strategy to be beneficial the winner’s advisers need to develop a cogent safe investment plan that will earn a return on the invested money that is higher than the interest rate used by lottery officials to discount the prize. Since “Cash is King” the idea of obtaining the money now is a seductive choice. The winner can live off the investment income generated by the lump-sum assuming he did not invest in Cousin Ned’s new solar powered rocket. When someone wins enough money for their family to live in luxury for the rest of their lives, it would be foolhardy to take risks. The money should be invested in a risk-adverse manner.

The lottery commission will withhold federal and possibly state income taxes. The winner receives a check net of those taxes. When the lottery announces the size of the after-tax amount the winner will receive to the media it is grossly overstated. That’s because the lottery did not withhold the full burden of taxes that the winner actually owes. Currently the highest federal income tax rate is 39.6%. The bulk of the winnings will ultimately be taxed at that amount when the winner files his tax return. The appropriate state income tax must be paid as well.

Assuming a flat 40% income tax, after discounting the annuity winnings to a lump-sum payment, a Mega Millions winner (after paying the full federal tax burden) will walk away with approximately 40% of the stated prize. With Powerball the winner will walk away with roughly 33.4%.

For example on August 20, 2103 the Mega Millions jackpot was $51 Million with a $34 Million pretax lump-sum cash prize. Powerball’s jackpot was $70 Million with the cash payout only being $39 Million pretax. These amounts will be less if the winner is responsible to pay state income taxes. Residents of Florida, Texas, Nevada, Washington, Alaska, South Dakota and Wyoming have no state income tax.

If you recall my lottery winner’s earlier quotation, his plan to share the bulk of his winnings with family makes me cringe. Be very careful. Our federal tax law contains a concept known as the “assignment of income doctrine,” based on a famous court case that used the “fruit and the tree” analogy.

The premise is that the tax law will not allow you to assign income to other people. If it is your income, you must pay the tax on the income. “He who owns the tree is taxed on its fruit.” Imagine a lottery winner who decides to give half of a $100 million prize away to his friends and relatives. He gifts $50 million. The winner is solely responsible for the approximate 40% income tax on the entire $100 million. Since he only kept $50 million for himself, after the $40 million income tax he is only left with $10 million. The decision to give money to others should be based on the final correct net proceeds after tax amount. Since a $100 Powerball win nets around $34 million, that should be the figure the winner should be considering when figuring out how to divvy up the prize.

The correct way to avoid an assignment of income problem is to buy your tickets in a group setting with those you want to share it with. My wife and I plan to share our winnings five ways by including our three grown sons. To protect ourselves with the IRS, at the beginning of the year the five of us wrote a check for $52, with “2013 lottery tickets” written on the memo line. I photocopied the checks placing the paperwork in a file before depositing them. With the $260, I buy $5 worth of tickets each week for my family. In doing so it allows the winner to alleviate the gift tax implications involved in large gifts. Also when the person dies a large chunk of the winnings is owned by others and kept out of the person’s estate. This could save huge amounts of estate taxes upon death. (Discussion of gift ande state tax is shown below)

My attitude is that if I’m going to make the effort to play a huge jackpot lottery than I should go to the trouble to make sure my family is provided with legitimate tax planning ahead of time.

You see, I take winning the lottery seriously. Back in 1982 I had five of the six numbers in the New York Lotto. The sixth number was a 10 while my number was a 9. I missed winning $6 million by one digit. I was playing the seat numbers of my students who got an “A” on my mid-term exam. If one student had just sat one seat over the first day of class…well it’s enough to make you jump off a bridge.

Some of the ideas expressed in this blog-post come out of my first novel 2003’s Lotto Trouble pictured above. Check out pages 16-18 of the novel as a tax professor lectures to his university class on the subject. Without spoiling the book, this professor bought a winning ticket and doesn’t know it. The clerk who sold it to him tracks him down and tries to steal it. People die in this tale of greed and redemption. See my book: Lotto Trouble, and also check out my blog post on the topic of unscrupulous lottery agents.

By the way, the tax implications get even worse. The lottery winner who was quoted above, made gifts to all of his family members. Unless a gift is given to one’s spouse it is subject to a wealth transfer tax known as the gift tax!

Every individual is allowed to give away $14,000 per year-per person (indexed for inflation) without gift tax implications. If you are married and your spouse agrees through gift splitting, it effectively doubles to $28,000. If one exceeds these gift amounts the excess is subject to gift tax at a 40% rate. However this tax only occurs if during your lifetime you have made excess gifts exceeding $5,250,000 (if married and gift splitting, the amount effectively doubles to $10,500,000. Amounts are indexed for inflation). These same amounts apply upon your death to exempt you from a 40% rate imposed by estate taxes, provided you did not use up your gift exemption amounts by making multi-million-dollar gifts while you were alive.

So if the winner gave away $50 million and is married approximately $40 million of these gifts are subject to gift tax at a 40% rate or $16 million. If you recall after income taxes the winner only had $10 million left. Guess what? After a $16 million tax the winner is left with nothing! The government would come after the recipients of the gifts for the remaining $6 million under the concept of “transferee liability.”

One could donate large amounts to charity. These amounts are deductible from your taxable income and are not subject to income tax or gift tax. In most instances the allowed deduction cannot exceed 50% of that year’s adjusted gross income. So if the winner is inclined to give away more than 50% of his winnings, income taxes might have to be paid on a portion of the money given to charity. Because of these limitations on deducting charity, to maximize tax savings, these donation should be made in the same year that you claim the income from the lottery prize.

Everything shown above are oversimplified examples designed to portray a general understanding. The calculations have been rounded. This blog-post should not be construed as offering or giving tax advice. Please consult your own tax preparer, CPA, or lawyer for specific advice.

Cash Kushel – Novelist and Associate Professor of Taxation and Accounting – Fordham University

PS  Please comment on what you would do if you won the lottery? Would you take a discounted lump sum or elect payments over 25 to 30 years? How would you share your prize? Would you seek a professionals help in investing the proceeds? Who would you turn to for advice on minimizing your tax burden?                                                                                                            [mc4wp-form]