Oct. 22, 2018
Winning the lottery is an amazing thing. Congratulations, if you have won. And as you’ve probably realized, nothing could have prepared you for the rush of emotions and adrenaline. Winning a large lottery has to be one of the most exciting events that can happen to a person. Their day starts like any other, but by the time they go to bed, their life has forever changed. If you’ve just won, you may feel a little anxiety mixed in with the excitement because of the many legal, tax and financial decisions you have to make right away.
Most lotteries allow the winner to take a lump sum or an annuity. The lump sum is a single cash transfer whereas the annuity is a series of annual payments. Most lottery winners, if given the choice, take the lump sum payment. They want all of the money immediately, and that is the main advantage. You have full and complete access to the money. The lump sum payment can have disadvantages, however.
First, if your lottery prize is less than $10 million, you may be in a better income tax position if you receive the proceeds over several years via an annuity rather than up front. Why? Lottery wins are subject to income tax in the year you receive the money. If you take the lump sum option, the entire $10 million is subject to income tax that year. 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. (In fact, the 2018 tax brackets allow individuals to have an income of $500,000 a year – and those who are married filing jointly, $600,000 – and still be in the 35%, rather than 37% bracket.)
Second, I strongly believe that for certain people who are more prone to spending, won’t get help from advisors and/or have certain familial pressures, the lump sum option can create more problems. There are lots of lottery winners who you never hear about who do just fine, but there are others who ruin their finances, relationships and lives after they win. For them, having less access to the full amount of the win is better. Instead of having to manage $15 million, they may be much better at managing $800,000 a year.
The annual annuity option is often scoffed at by winners, but the big advantage for taking the money over time is that it provides you with a "do-over" card. We've all heard the stories of lottery winners who have lost it all in a few short years. By receiving a check every year, even if things go badly the first year, you will have many more chances to get it right. This is a significant advantage of the annuity, but it’s often difficult to convince the winner of the merits of an annuity. Couple the winner’s reluctance to spread their win over time with the financial advisor’s desire to manage a bigger pool of assets and you can see why so many choose the lump-sum option.
What option is best for you? The annuity is not as sexy as a big check, but I’ve never heard anyone complain about receiving a check in the mail every year.
There is a third option, however. If you like the idea of having access to all the money but also like the comfort, predictability and security of a check, you can use some of the lump sum win to buy a private fixed annuity. This lump-sum private annuity option doesn’t have the advantage of spreading your income out over time to minimize income taxes, but for the winner who is concerned that they will face pressure or make questionable financial decisions, the annuity can alleviate much of their concern.
One strategy that works well for some clients is to get a private annuity that pays an amount each year to cover their basic living expenses (e.g., property taxes, insurance, food, clothing, medical, etc.) This strategy provides anxious winners the comfort of knowing they will never go broke and will always have a certain standard of living covered.
From a strictly financial perspective, is it better to take the annuity or the lump sum? This is a complex tax question that depends 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, how much you will withdraw from your portfolio each year and the rate of return you will receive on your investments. You will want to work with your financial advisor, tax attorney and CPA to determine which option is best for you, but as a rule of thumb, if you can earn an annual return of more than 3% to 4%, the lump sum option makes more sense over the annuity at the end of 30 years.
This article is adapted from the book, "The Sudden Wealth Solution: 12 Principles to Transform Sudden Wealth Into Lasting Wealth."