Congratulations, you won the lottery! So, now what? Certainly, there’s lots to do. Build a barbed wire fence around your home, start digging a moat, change your phone number… Busy times for the newly wealthy!
Before any of that, you have one important decision to make. Probably the most important one you’ve ever had to make. Do you take the cash value today or do you take the annual payments? There are different ways to look at this question, but the analysis should begin with the math. Each state may be a bit different, but the California Lottery gives the option of a cash lump sum that they estimate at around 45-55% of the jackpot amount. If you select the payment option, you will receive an increasing payment over the course of 26 years. The first payment will be 2.5% of the jackpot, increasing to the 26th payment of 5.1% of the jackpot amount.
They give a sample payout of a $7 million jackpot, which is the lowest jackpot possible in the California Super Lotto. Their site goes so far as saying, “these payments would gradually increase each year until the final payment of $357,000 – a 100% increase over the first payment!” They say this as though it’s a good thing that you get more of your money later than sooner. What again is the first rule of Time Value of Money? Oh yea, money today is worth more than money tomorrow.
Based purely on the math, which one should you pick? Well, the range of 45-55% for the cash value complicates things, but here are the calculations. If the cash value is 45% of the jackpot, the Internal Rate of Return (IRR) on the payments (the return you effectively receive on your stream of payments) is 6.17%. If the cash value is 50% of the jackpot, the IRR on the payments is 5.24%. If the cash value is 55% of the jackpot, the IRR on the payments is 4.43%.
In other words, if you think you can generate a return higher than the respective IRR, you should, based on the math, take the lump sum.
But it’s not that simple. We have all heard stories of people winning the lottery and within a few years find themselves divorced, friendless and broke. Can you handle that much money all at once? Most will react, “yes, I can handle it” or perhaps a more smart alecky, “why don’t you give me the money and we’ll find out.”
Most people would have a difficult time with that sort of money, and may be susceptible to scams, poor investments, wild spending, over gifting or lending to friends and family. Here’s where you throw the math out and consider the psychology. Most people want an income. Not an asset or a business, but an income. The payment stream gives them that. In the California Lotto example, the first year’s payment would be $175,000. Let’s say they blow through it. Wild trips to Vegas, new car, etc. Worry not, they have $189,000 coming next year. That one disappears in gifts and loans that will never be repaid. In year three $196,000 is paid. That one goes to the scam artists. At some point, I have to believe that this person is going to figure out how to actually get some qualified, legitimate help, and take care of that money. With a lump sum, he has one shot. Blow it, and the money is gone.
Another consideration is income taxes. Your winnings are subject to Federal taxes, and perhaps state taxes. Surely, a large lottery payout will bump you into a higher tax bracket (assuming you aren’t already there), but how high? In 2010, a couple married filing jointly can make up to $373,650 before reaching the highest tax bracket. Depending on the size of your winnings and other income, you might remain below the top marginal tax bracket by taking the payments. As the payment increases, along with your other income (investment earnings, for example), you are more likely to find yourself in the top tax bracket in the future. A lump sum is likely to be taxed at today’s highest bracket.
Of course, this calls into question the future of income tax rates. Income tax rates are at a relative historically low level. If rates rise in future years, you may be better off paying taxes at today’s top rate rather than tomorrow’s even higher rate.
Are estate taxes a consideration? The answer is largely unknowable because the future of estate tax laws are not known. The winnings themselves are largely a non-factor. A lump sum increases the size of your estate, increasing the likelihood of being subject to estate taxes. Taking the payments does not eliminate this impact. The present value of the remaining payments is calculated as part of your estate. However, possession of the lump sum may allow you more options in creative estate planning strategies.
What if you die before the payments are finished? In most states, the remaining payments will be considered part of your estate, and gets passed on to your heirs, subject, of course, to income and estate taxes. It’s a good idea to verify this with your state.
By Eric Toya, CFP®
Special to FPA