Taxes on a $1.4 billion Powerball jackpot could be $400 million-By Bill Bischoff

The pitfalls of hitting the big one

People walk past a sign advertising the Powerball lottery in New York, Monday, Jan. 11, 2016. The jackpot is so big that billboards around the country have to advertise the prize as $999 million because they're not built to show billions. (AP Photo/Seth Wenig)

The next Powerball drawing is worth an estimated $1.4 billion (it may be even higher by the time you read this), and the odds are good that there will be a winner this time.
If there’s only one, we will have a new member of the billionaire club. Right? Wrong, because your friendly tax collectors are silent partners in the deal. Here’s the story on all the tax hits on a huge payout.
Annuity versus cash option
As I write this, the projected jackpot for the Jan. 13 Powerball drawing is a whopping $1.4 billion. But that number is based on the winner taking his or her money in the form of a 29-year annuity. You get the first payment right away, and then one annual payment for the next 29 years. On the other hand, if you choose the cash option, you get all the money right away, but you get less. The projected cash-option jackpot is “only” $868 million. What’s the biggest reason to choose one option or the other? You guessed it: Taxes.
If you choose the annuity option and then die before collecting all your rightful proceeds (a distinct possibility if you are not a youngster), the present value of the remaining payments will be included in your taxable estate for federal estate tax purposes. The first $5.45 million (indexed for inflation in future years) will be sheltered by your federal estate tax exemption, but anything in excess of that amount will be taxed at a 40% rate. Depending on where you live, there may be a state death tax hit, too. Your heirs would have to figure out how to pay the tax hit(s) on money they have not yet received. I’m sure there are ways to borrow what’s needed to pay death taxes, but I doubt those ways are cheap. So if you’re not a healthy millennial, the cash option could be the better choice, despite what you might read elsewhere.
And if you’re a youngster in robust good health, and choose the annuity option — but you live in a high-tax state like New York, Massachusetts, Minnesota, or Oregon (oddly enough, California does not tax lottery winnings) — can you move to Florida or Nevada or Texas, which have no personal income taxes, and thereby avoid any state income tax hit on your future lottery annuity payments? It depends on the laws of the state where you currently reside. This is a question to be researched by your newly hired tax professional (more on that later).
Federal income tax
Lottery jackpots are fully taxable. And big jackpots are taxed at the maximum federal rate of 39.6%. On an $868 million cash payout, the federal income tax hit would be about $344 million. Ouch! Federal income tax will automatically be withheld from your prize, but only at a 25% rate. So on an $868 million payout, you would still owe the federal government almost $127 million. You have the same underpaid tax issue if you receive big lottery annuity payments, but the underpaid amount for each year is much smaller. In any case, failure to recognize that additional tax is still owed on lottery winnings is one big reason why some winners wind up in bankruptcy court a few years later.
State and local income tax
Say a big lottery winner is “unlucky” enough to live in a state with a personal income tax. In most states, the tax rates on high-income individuals range from 5% to 10%. If the rate is 7%, the winner of an $868 million cash payout will owe the friendly state tax collector about $61 million. But if you live in New York City, you face an 8.82% state income tax rate plus another 3.876% for city income tax. Oof! The state income tax rate in Massachusetts is an oppressive 12%, and the 11% rate in Hawaii is no bargain. Depending on where you live, automatic withholding of state and local income taxes may or may not occur. So another big reason why some lottery winners wind up bankrupt is failure to plan ahead for these tax hits.
Federal gift tax
Despite having already lost many millions to the Feds (and maybe to your friendly state and city tax collectors, too), your tax situation can quickly deteriorate even further if you share your newfound wealth generously with friends and loved ones. That’s because you’ll owe the 40% federal gift tax after you’ve given away more than the $5.45 million federal gift tax exemption (adjusted for inflation in future years). Say you give away $25 million to siblings, children, parents, aunts, uncles, and friends. The gift tax bill would be about $7.8 million. So please don’t give away anything until you’ve talked to your newly hired tax pro.
Death taxes
Now let’s assume that you don’t give away any of your $868 million cash jackpot. You just pay your $344 million tax bill to the Feds and your $61 million state tax bill. So you have $463 million left ($868 million - $344 million – $61 million). That should be more than enough to at least last for the rest of your life (I hope). But if you massively overindulge and die of a heart attack later this year, your estate will owe a $183 million federal estate tax bill [40% x ($463 million – the $5.45 million exemption)]. Of the $868 million you started off with, $280 million is left. That means almost 68% has been lost to taxes. Ouch! If your state income tax rate is higher than 7% or if your state charges a death tax, it could be even worse. So don’t tell me the rich don’t pay enough in taxes. That said, I’m still open to winning the Powerball.
The bottom line
If you’re lucky enough to become a really big lottery winner, please take my advice: hire a super-competent tax pro, a super-competent attorney, and a super-competent financial adviser the next day. Then don’t do anything with your money until you’ve talked to all three. That way, your big jackpot will be a blessing instead of a curse.
Culled from MarketWatch