Should I take my lottery winnings in a lump sum or annually?
I recently won $1,000,000 in the lottery. If I take the lump sum option, I'll get about $500,000 after taxes. If I take the payments over 20 years, I will get about $37,000 a year for 20 years after taxes. Which is the best option?
There is no simple answer. But congratulations! Let's see if you can avoid the fate of most lottery winners who go bankrupt in 5 years . . . or less. Here is the missing information I would need to give a reasonable answer:
- What is your age?
- Are you single or married? Children? Are you happy with your current lifestyle and is taking care of your family after your death more important than living it up now?
- In which state do you live? It's essential to know your total tax hit.
- What is your life expectancy? Here's a good calculator for that purpose: https://livingto100.com/calculator This is a difficult but important number because if you're 75 and the calculator says your life expectancy is 74, have a big party! If you're 35 and expect to live to 95, hire a financial planner.
- What are your debt details, i.e. amounts, terms & interest rates? Paying off debt is an investment that cannot be taken away from you (unless you carelessly acquire more!).
Depending on all of the above, there are various tax-advantaged options you could consider. This is not a -do-it-yourself issue! You need an impartial, experienced 3rd party to see through the euphoria, to soberly reflect back to you your current financial situation, and realistically project what's possible- and not possible -with this windfall.
If you take the lump sum, the following scenario might be worth a look:
$500,000 invested for 20 years at an assumed 8% would produce $50,926 per year. That is definitely an increase from the $37K, however be aware of the two variables (1) rate of return and (2)DISCIPLINE to not take any money earlier.
Taking the $37K per year would guarantee everything. You are sacrificing $13K per year for the guarantee.
So I think you need to make a call on if you are disciplined and smart about investment management, or if the guarantees make more sense for you.
First, congratulations on your good fortune. This is truly a life changing event and it is great that you are taking some time to ask the right questions. As the previous advisors have responded, the correct answer really depends upon your situation and your goals.
Second, in order to know what course of action is right for you, you need to answer some basic questions that will steer you toward a solution. These are a couple to get you started.
1) If you take a lump sum, are you likely to spend it? If you think you will be tempted to spend the proceeds and live large until they are gone, taking the annuity stream may be a good option for you, regardless of the tax situation. A lot of research shows that lottery winners who quickly spend their windfall actually end up much worse off psychologically than if they had never won the money at all. Creating a system to combat your money weaknesses is a good way to protect yourself from bad decision making.
2) Do you need the cash now or can you afford to save it and let it help solidify your future? If you have current cash needs that require a larger sum than the annuity payment, taking the lump sum may be a smart approach. While the cost in taxes is high, if you can retire high cost debt or avoid taking on new high cost debt, it may be worth it. Saving a large percentage of the lump sum in a diversified portfolio is a great way to bolster your current retirement savings. Both of these activities can significantly improve your current financial situation, and through good planning you may be able to generate a significant stream of income from the assets to partially offset not having the annuity.
3) What do you plan to do with the money? Determining the ultimate purpose for the funds is really the goal here and will help you figure out what to do. Do you need a cash flow stream to pay current expenses and retire high cost debt? Are you thinking of buying a house and need a down payment? Do you have charitable ambitions?
I realize this is a short list, but you need to think a lot about what your needs are, how you handle money, and what your tax situation is. Start by answering these questions and then reach out to a local fee-only financial advisor, CPA, or other trusted advisor to help you run the numbers and help finalize a plan. Take your time to make the right decision for you and don't be pressured by an advisor or anyone else to do something you are not comfortable with. If you choose to work with a financial advisor, I would suggest that you meet with three independent fee-only advisors in your area and try to find someone who is a good fit for you. If anyone tries to pressure you into buying a particular product (annuity, insurance, etc.) in the initial meeting, run away fast.
From a purely economic angle, taking the lump sum is better because ...
If you invest the money in a moderate portfolio that yields 7% return on average, you can expect to earn $35K a year and as the years pass, the expected earnings will increase (since the base will increase).
If you use a 5% rate to discount the $37K a year cash flows to present value, you will get $484K. That's less than $500K.
However there are many reasons you should not take out the lump sum.
1. If you are like the typical investor, you don't know how to invest and you may lose money in investments.
2. If you are like the typical human being, you will have instant gratification bias, meaning you are likely to spend the money and acquire lifestyle habits that are not sustainable in the long run.
3. Lastly, when you have $500K in your pocket, you will be the target of shameless relatives and "friends" as well as unscrupulous sales people.
I would highly recommend you use the installment option. On top of that, use half of $37k to improve your lifestyle and the another half to invest in an index fund. Let assume the fund returns about 8%. In 20 years, you will have $612K. That will give you another 20 years of financial security.
This type of question is common among lottery winners and there is not a "one-size-fits-all" answer. A lot depends on your age, health status, other assets you may have, etc. There are a few general items to consider when making the decision of lump sum vs. the 20 year payout:
1. Investing and controlling your money: If you decide to take the lump sum, you are able to take the $500,000 and invest that amount in stocks, bonds, cash, etc. The goal for investing the money is to provide after-tax amounts that would be greater to you than taking the annual payments. However, investments may have risk and could lose money in the future. Ultimately, you have more control over the funds and can choose whether you want to invest them, spend them, etc. This can be both a positive and a negative.
2. Tax rates today vs. in the future: We know what the federal and state tax rates are today if you take the lump sum option or the 20 year payout. What we don't know are the federal and state tax rates in the future. If you choose to take the lump sum today, your income will most likely put you in the highest tax bracket where you could pay taxes at a rate close to 40% federally plus state taxes. If tax rates go up in the future, it may be more beneficial to take the lump sum now vs. paying potentially higher taxes in the future. If tax rates go down, there may be more benefits to taking the monthly payment.
3. Spending the lump sum: Winning $1,000,000 can be a life changing event for someone. If you are concerned that you may spend all of the lump sum and run out of money, consider taking the annual payment. In this way, you are restricting how much you can spend, but you prevent yourself from running out of money for at least 20 years.
Those are just a few of the points to consider when looking at the lump sum vs. annual payment. Carefully consult with your advisors (CPA or Enrolled Agent, financial advisor, estate attorney) to make sure you are reviewing the decision carefully. This one decision can have a direct impact on you for 20+ years.