What Is a Lump-Sum Payment?
A lump-sum payment is an often large sum that is paid in one single payment instead of broken up into installments. They are sometimes associated with pension plans and other retirement vehicles, such as 401k accounts, where retirees accept a smaller upfront lump-sum payment rather than a larger sum paid out over time. Lump-sum payments are also used to describe a bulk payment to acquire a group of items, such as a company paying one sum for the inventory of another business. Lottery winners will also typically have the option to take a lump-sum payout versus yearly payments.
[Important: It is not always best to take the lump-sum payment in lieu of periodic annual payments. Be sure to calculate the net-present value if offered the choice.]
The Basics of a Lump-Sum Payment
There are pros and cons to accepting lump-sum payments rather than an annuity. The right choice depends on the value of the lump sum versus the payments and one’s financial goals. Annuities provide a degree of financial security, but a retiree in poor health might derive greater benefit from a lump sum payment, if they think they will not live long enough to receive the entire benefit. And by receiving an upfront payment you can pass on the funds to your heirs.
Also, depending on the amount, an upfront payment might enable you to buy a house, a yacht or another large purchase that you would otherwise not be able to afford with annuities. 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. Or, of course, you could lose it all. For more on whether to accept the traditional, lifetime monthly payments or take a lump-sum distribution, read Lump Sum Versus Regular Pension Payments.
- A lump-sum payment is an often large sum that is paid in one single payment instead of broken up into installments.
- Lump-sum payments may instead be annuitized as periodic payments.
- Based on interest rates, tax situation, and penalties, an annuity may end up having a higher NPV than the lump-sum.
An Example of Lump-Sums Vs. Annuity Payments
To illustrate how lump-sum and annuity payments work, imagine you won $10 million in the lottery. If you took the entire winnings as a lump-sum payment, the entire winnings would be subject to income tax in that year, and you would be in the highest tax bracket. However, if you choose the annuity option, the payments could come to you over several decades. For example, instead of $10 million of income in one year, your annuity payment might be $300,000 a year. Although the $300,000 would be subject to income tax, it would keep you out of the highest state and federal income tax brackets.
Such tax questions depend on the size of the lottery win, current income tax rates, projected income tax rates, your state of residency when you win, in which state you will live after the win, and investment returns. But if you can earn an annual return of more than 3% to 4%, the lump sum option usually makes more sense with a 30-year annuity.
Another big advantage of taking the money over time is that it provides winners with a "do-over" card. By receiving a check every year, winners have a better chance of managing their money properly, even if things go badly the first year. For more on choosing to take an annuity or a lump sum, read Lottery Winnings: Take the Lump Sum or Annuity?