Winning a prize is a great thing, but you don't want to risk any unwelcome surprises that may come with it. One of these could be income taxes. Will the taxman come for your winnings? How can you prevent tax problems? And what should your first stop be after winning a significant prize? Here's what every taxpayer needs to know. 

Are Prizes Taxable? 

The short answer to this question is yes. In general, both the IRS and your state tax agency are likely to deem the value of your prize as taxable income. While state tax rules vary, the IRS taxes most prizes at similar rates to regular earned income such as wages or business income. 

How Is the Prize Valued?

It may seem logical to tax cash prizes, but what if you win a car or a vacation? In these cases, you will generally be informed of the value of your prize as determined by the organization which gave it away. This value is often reported on IRS Form 1099-G. If you disagree with the valuation made by the organization, you may ask them for verification or proof of their calculations.

Will Your Tax Rate Change?

In addition to adding more taxable income, the prize may have an unexpected effect: increasing your tax rate.

The United States (and many states) has a progressive tax system in which a taxpayer is taxed at a higher percentage as their income rises. A prize can create a bump in your annual income which subjects you to a higher rate for the year in which you win. So your taxes might otherwise be taxed at 22%, but a portion of that income may instead be taxed at 24% or more. 

How Can You Avoid Tax Problems?

The most important thing to do when you win a prize is to learn its taxable value. If you win cash or an asset you plan to liquidate, set aside a portion of the proceeds for tax purposes. Some prizes will have a percentage withheld for taxes automatically. But if the item is an asset such as a vacation, you may need to boost your wage withholding to avoid a tax surprise.

In addition, you can deduct related expenses for most winnings and prizes. Gamblers can generally deduct what they put into gambling games and lost. Others, like athletes or other professionals, may declare the income as a business enterprise and deduct related business expenses. 

Where Should You Go First?

After winning any prize, your first stop should usually be to meet with an income tax preparation service in your state. They will help you decide how much to set aside, what you may deduct, and how to minimize the tax impact. Call a tax professional such as Michael F. Simonds, CPA today to make an appointment so you can enjoy your prize tomorrow.