What to do with lottery prize money

(MoneyWatch) The winners of last night's historic $587.5 million Powerball lottery jackpot realized a dream that was chased by millions of folks around the country. But for the few that won, this life changing financial windfall can create as many financial problems as it solves.

If you come into a large amount of money that you have not planned for, play it smart and consider this financial game plan to deal with it.

Plan to pay taxes:

Some lump sum payments which typically are not subject to income taxes include tax refunds (unless you claimed a deduction for the taxes in prior years), gifts you receive and life insurance death benefits.

But payments for lottery or prize winnings and other lump sums, including severance and bonus pay, proceeds from the sale of a business or real estate, payments from court awards and proceeds from the exercise of stock options are all generally includable in income in the year received.

If you think that winning a multi million dollar lottery would have you set for life, think again. Some people who receive prize winnings later face IRS charges for failure to pay taxes on that prize money. The taxes can be as much as half of the prize amount and interest and late payment penalties can amount to another third.

Some people are shocked to learn that non-cash prizes are also taxable. When Oprah gave away cars to her audience members, the winners quickly learned that "free" prizes were not exactly free. Each recipient had to pay income tax on the value of the car they were given.

Anyone who receives a lump sum payment should first consult with an accountant or tax attorney. You will need to know if the payment is taxable, how much the taxes could be and when the tax should be paid. That way, you'll know how much of the lump sum needs to be set aside or reserved to pay the taxes. Remember, the IRS will not accept the "I didn't know I had to pay!" as a defense and getting into trouble here can cost you thousands of dollars in penalties, fines and even jail time.

Make big decisions slowly

People who receive large one-time payments should take anywhere from six months to a year before making any long term decisions and changes that involve money. The guideline is that the larger the amount received, the longer the time to make decisions. This gives someone time to think through all available options, some of which can be new and unfamiliar. That's not to say that certain decisions that are clearly beneficial, such as paying off debt, should not be done immediately. But avoid bigger financial decisions such as selling a home, quitting a job or making long term investments until some time has passed and all options are understood and carefully considered.

Protect large deposits

One of the first questions asked by people who receive a check for a large sum is, "What do I do with this check?" The best course of action is usually to make a bee-line to your bank and deposit the check. This is to ensure that the funds are cleared and credited into a financial account safely and quickly. After that, depositors need to know that their bank account balances are insured from bank failure by the Federal Deposit Insurance Corporation and the standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category. This coverage is in place through 2013, unless extended.

For amounts at one insured bank totaling more than $250,000, different ownership categories of accounts are covered separately, so you may qualify for more than $250,000 in coverage at one insured bank if you own deposit accounts in different ownership categories. This will apply to accounts titled separately in each spouse name and jointly. Also, some banks may tell you to deposit your money into their insured money market account, or IMMA, as this may currently pay a higher rate of interest. These money market accounts, unlike money market mutual funds in brokerage accounts, are still insured under the FDIC.

Get more interest

The next step is to check out higher interest rates for your cash while you are taking time to consider longer-term financial decisions. Check out the interest rates offered by other banks and credit unions. Also check out interest rates at brokerage firms' money market funds.

Make no promises

When very large amounts of money are received, don't casually promise to buy anything or give anyone any money. Your new found wealth will be a lightning rod for attracting attention of family and friends who may hold you to everything you say or do. If you don't deliver on a promise, you may find yourself on the receiving end of another person's lawsuit claiming breach of an agreement or contract. It's better to keep your lips zipped about your generous intentions than to become the recipient of hostility because your expressions were taken more seriously than you intended.

Strengthen your safety net

When suddenly coming into very large amounts of money, you not only have more money but also have more money to lose. Increase your liability coverage by purchasing an excess liability insurance policy and coordinating the coverage with your auto and homeowners policies. Increase your personal property coverage to ensure coverage for any new automobiles, homes and property you purchase. Some advice also given is to purchase a security system, hire a security guard for a period of time and even purchasing kidnap and ransom insurance to protect you and your family from potential risks that come with becoming suddenly wealthy.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.