Lottery Tax Rates Vary Greatly By State

Fiscal Fact No. 295

With the Mega Millions jackpot reaching a record $540 million, Americans in 43 states and the District of Columbia are lining up to buy tickets for Friday's drawing. Everyone knows that winners must choose between a lump sum payment and installment payments, but where you purchase your winning ticket also matters, due to state income and withholding taxes.

As with wage income, some amount of lottery winnings is withheld for the government before you calculate your total tax bill when filing your income tax the following year. While lottery winnings of $600 or less are not reported to the IRS, winnings in excess of $5,000 are subject to a 25 percent federal withholding tax. In other words, if one person wins the jackpot and chooses the $389 million lump sum payment, $97 million will go straight to the IRS. Next April, the jackpot winner or winners can see if any of that amount gets refunded, or if they owe even more.

The same is true at the state level. While lottery winnings are subject to state income tax in most states, withholding tax varies from zero (California, Delaware, Pennsylvania, and the states with no state income tax) to over 12 percent in New York City (see Table 1). Arizona and Maryland have withholding rates for non-residents, so an out-of-state winner who bought a ticket in those two states could face double withholding.

Table 1: Lottery Withholding Tax Rates by State

Source: USA Mega.

States rely heavily on lottery revenue, collecting an average of $58 per person in "profit" aside from any income tax collections. (See Table 2.) While no government labels its lottery as a tax—North Carolina fought to a tie in their state supreme court recently to avoid such a label—lottery "profits" are an implicit tax. After prizes have been awarded and operating costs have been covered, the remaining money is transferred to state coffers. To the extent this revenue is used for general government purposes, it is a tax. Further, because state lotteries pay out an average of only 60 percent of gross revenues in prizes (compared to about 90 percent for casino slot machines or table games), state-run lotteries are only viable as a monopoly, in conjunction with a ban on private lotteries.

Some argue that while it is a tax, it is a "voluntary" one since the revenue is handed over to the government enthusiastically. But this argument confuses the purchase of a product with the payment of the tax on the product. True, the purchase of the product is voluntary, but the tax portion of the ticket price is not, just as a sales tax is compulsory on the purchase of clothing or books. The voluntary nature of the purchase does not make the tax any less of a tax.

Table 2: State Implicit Lottery Tax Revenue Per Capita, Fiscal Year 2010

Note: The implicit tax revenue is the portion of lottery revenue kept by the state, or the "profit." It does not include federal or state income tax on winnings.

Source: U.S. Census Bureau, Tax Foundation calculations.