You hear it all the time: the rich don't pay their fair share in taxes. Baloney! For proof, consider the daunting tax bills that will be faced by winners of the recent Mega Millions jackpot. Here's the true story.
The jackpot for the March 30 drawing was a whopping $656 million. There were apparently three winners. Each could choose to receive an annuity that would pay out about $219 million over 26 years. However if a winner selects the cash option (the only sane choice in my opinion), he or she would collect about $128 million before taxes. The key words are "before taxes."
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Federal Income Tax
Lotto jackpots are fully taxable. And huge jackpots are currently taxed at a maximum federal rate of 35%. So the winner of $128 million will owe the Internal Revenue Service about $45 million. That leaves about $83 million.
State Income Tax
Say a new Mega Millionaire 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 $128 million will owe the friendly state tax collector about $9 million. That leaves about $74 million.
One of the big reasons why some lotto winners wind up bankrupt is failure to recognize the federal and state income tax hits before it's too late.
Federal Gift Tax
Despite having already lost $54 million to the IRS and the state tax collector, your tax situation can quickly deteriorate even further if you share your newfound wealth generously with loved ones. That's because you'll owe a 35% federal gift tax after you've given away more than the $5.12 million exemption. Say you give away $25 million to siblings, children, parents, aunts, uncles, and friends. The gift tax bill would be about $7 million [($25 million - $5.12 million exemption) x 35% = $6.958 million].
Say you give away another $25 million to your grandkids. You will get socked with a 35% generation-skipping transfer tax (GSTT) on gifts in excess of the $5.12 million GSTT exemption. Worse yet, the GSTT is on top of the gift tax. The gift tax on the gifts to your grandchildren is about $9 million ($25 million x 35% = $8.75 million), and the GSTT is about another $7 million [($25 million - $5.12 million GSTT exemption) x 35% = $6.958 million].
Bottom line: you owe $77 million in taxes and you've given away $50 million to loved ones. Guess what? You only have $1 million left for yourself ($128 million - $77 million - $50 million = $1 million). Oops! Another big reason why some lotto winners wind up bankrupt is failure to understand the gift tax rules before it's too late.
Federal Estate Tax
Now let's assume you don't give away any of your $128 million. You just pay the $54 million in income taxes and break even for the rest of your life, dying with a cool $74 million. If you kick the bucket this year, your estate will owe federal estate tax equal to 35% of the excess over the $5.12 million exemption. That would amount to about $26 million [($74 million - $5.12 million exemption) x 35% = $25.9 million]. Your heirs would get $48 million (nothing to sneeze at), but $80 million was lost to taxes. That's a whooping 62.5% of what you started with. Ouch!
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State Estate Tax
We're not done yet. If you live in one of the 22 states with a state death tax, your estate could be whittled down even more. The tax hits just keep on coming!
It Could Get Even Worse
Unless Congress takes action and the president (whoever he is at the time) approves, the maximum federal income tax rate for 2013 and beyond will be 39.6% (up from the current 35%). The maximum federal gift and estate tax rate will be 55% (up from the current 35%), and the gift and estate tax exemptions will be only $1 million (versus the current $5.12 million). If these changes come to pass, the tax hits on future Mega Millionaires will be far bigger than what I've shown here.
The Last Word
Tax-wise, the only difference between Mega Millionaires and people who have gradually become wealthy through hard work over many years is the hard work. So it's just plain wrong to claim that rich folks don't pay enough in taxes, unless you really believe the government should be entitled to confiscate 60% or more of their wealth. On the other hand, it's true that once you become rich you can take advantage of some nice tax breaks that are not readily available to the rest of us. For example, the new Mega Millionaires can invest what's left of their dough after paying income and gift taxes and pay only a 15% federal rate (for 2012) on long-term capital gains (20% in 2013 and beyond). But they will have to take risks to get that low rate, and they can only invest what remains after paying the heavy tax hit on the front end.