What is a 'Lump-Sum Payment'
A lump-sum payment is a one-time payment for the value of an asset such as an annuity or another retirement vehicle. A lump-sum payment is usually taken in lieu of recurring payments distributed over a period of time. The value of a lump-sum payment is generally less than the sum of all payments that you would otherwise receive, since the party paying the lump-sum payment is being asked to provide more funds up front than it otherwise would have been required to.
BREAKING DOWN 'Lump-Sum Payment'There are pros and cons to accepting lump-sum payments over annuitized payments, and in most cases, the right choice depends on the value of the lump sum versus the payments and your financial goals.
How Lump-Sum and Annuitized Payments Work
To illustrate how lump-sum and annuitized payments work, imagine you won a lottery worth $1.5 billion. If you choose a lump-sum payment, you receive $930 million immediately, and if you choose annuitized payments, you receive $1.5 billion over 30 years. With the lump-sum payment, the IRS takes 25% in taxes off the top, but because these earnings push you into the top tax bracket, you ultimately pay about 40% in income tax, reducing your lump-sum payment to $558 million.
In contrast, the annuity payments vary each year and get larger annually. The first one is about $16 million while the final payment in the 30th year is roughly $65 million. On average, each annual payment is $50 million. After applying 40% tax, that number falls to $30 million. Neither of these explanations take into account state or local income taxes, but regardless, taking annuitized payments results in receiving more cash. However, that doesn't necessarily mean you should never take a lump-sum payment.
Benefits of Lump-Sum Payments
The main benefit of a lump-sum payment is that you get all of the money upfront. Depending on the amount, you may buy a house, a yacht or another large purchase that you may not be able to afford with the annual payments. Similarly, you can invest the money and potentially earn a higher rate of return than the effective rate of return associated with the annual payments.
Risks of Lump-Sum Payments
Lump-sum payments open you to risk as well. If the money is invested aggressively, you could earn a lot of money, or you could lose it all. Similarly, you can accidentally spend all of a lump-sum.
Benefits and Risks of Annuitized Payments
Annuitized payments damper mistakes. Even if all of the money is lost one year, you receive a payment the next year, and that provides you with a degree of financial security. However, in some cases, annuitized payments, especially payments associated with pension plans, often stop at your death, meaning you cannot pass the payments to heirs. In contrast, if you had accepted a lump sum, you could have invested the funds and left them to your heirs. Another risk of annuitized payments is that the firm may default before it makes all of the payments.