Taxes hang over winnings

Personal Finance

May 08, 2007|By Eileen Ambrose | Eileen Ambrose,Sun Columnist

Frank of Reisterstown says one thing seems to be overlooked in the hoopla over TV game shows: taxes.

"For example, in Deal or No Deal, the contestant is asked, `What would you do with $1,000,000?'" he writes in an e-mail. "In all these contests, taxes don't seem to be considered. Winners do have to pay taxes on their winnings, don't they?"

You bet. Just ask Richard Hatch, the Survivor winner whose serving time in prison for tax evasion. As if no one was going to notice that a naked contestant won $1 million.

Winnings are taxed like ordinary income. Million-dollar prize winners will find that most of the money is federally taxed at the highest rate of 35 percent. That rate applies to taxable income exceeding $349,700. And don't forget state income taxes on top of that.

Most of us won't be winning millions on TV. We're likely to win more modest sums in bingo, keno, lotteries and horse racing. This money also must be reported as income, but the tax rules differ depending on the size of the prize and the type of gambling.

Given that the Preakness is just around the corner, it's worth remembering the tax rules for the ponies.

The Pimlico Race Course will give you - and the Internal Revenue Service - a Form W-2G if you win $600 or more and the winnings are at least 300 times the amount wagered. Dave Scheing, director of auditing and cash operations at Pimlico, says the tracks issues 12,000 to 14,000 W-2Gs to individuals each year.

If you win more than $5,000, the track will withhold federal and state taxes. The withholding rate is 25 percent for federal taxes and 7.5 percent for state taxes for Maryland residents. You'll need to supply your name, address and Social Security number. Refuse to give your Social Security number, and the track is required to withhold 28 percent of your winnings for Uncle Sam.

The silver lining for unlucky gamblers: You can offset winnings with any gambling losses over the course of the year.

"The only way to deduct their losses is if they itemize" says Seth Hammer, associate professor of accounting for Towson University. "If they don't itemize, they are stuck."

Regular gamblers should keep a diary of wins and losses, dates and the names and addresses of those who were with you in case you need to verify those deductions, he says.

Tracy of Forest Hill left her job because of a disability and wonders if she should roll her 401(k) account into a traditional IRA or a Roth IRA. The 50-year-old plans to tap the money when she reaches the usual retirement age. At that time, her husband also will be retired, and the couple expect to be in a lower tax bracket then.

Columbia financial planner Michael Kitces says Tracy basically has two decisions: First, should she keep the money in the 401(k), or roll it over to an IRA? Second, should she convert to a Roth?

"The primary reason to keep the funds in the 401(k) would be any minor creditor protection benefits ... if that's important to her," Kitces says. If it isn't, then the IRA likely will give Tracy more investment flexibility.

Roth or traditional? Right now to open a Roth using 401(k) money, Tracy must first roll the cash into a traditional IRA and then convert to a Roth.

If Tracy rolls her 401(k) money into a traditional IRA, she won't pay any taxes at the time. But later when she takes the money out in retirement, her withdrawals will be subject to ordinary income tax. This is appealing to those who will be in a much lower tax bracket in retirement.

If she converts to a Roth, she will pay ordinary income tax on the money at the time of conversion. After that, withdrawals in retirement are tax free. The Roth is attractive for workers who will be in a higher tax bracket in retirement.

(To move money from a 401(k) to a Roth is a two-step process. First, cash is moved to a traditional IRA and then converted to a Roth. Beginning next year, money can be rolled over directly from a 401(k) to a Roth.)

Two factors make the traditional IRA more attractive for Tracy - and possibly less costly.

First, Tracy and her husband expect to be in a lower tax bracket in retirement.

Also, it appears that Tracy would be using a big chunk of her IRA money just to pay the taxes for the Roth conversion.

Losing a big sum to taxes is bad enough, but the IRA cash used to pay the tax could be subject to a 10 percent penalty unless she meets the IRS definition of "disabled," says Stuart Ritter, certified financial planner with T. Rowe Price Associates.

Leo Casper, a certified public accountant in New Jersey, says Tracy can roll her money into traditional IRA now and see if her situation changes. He expects future taxes will be higher. If Tracy decides to convert to a Roth, doing so in 2010 will allow her to spread the tax bite over two years, he says.

Questions? Comments? Write personal.finance@baltsun.com.

MORE AMBROSE Find Eileen Ambrose's column archive at baltimoresun.com/ambrose

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