A question that I have been asked on more than a few occasions is whether it’s better to take the lump sum payment or the yearly payment annuity if you happen to win the lottery. This is really a mute point for me since I don’t play the lottery, but it’s still an interesting question to ponder. One would think that the answer to this question would be quite easy, but the reality is that due to a number of factors. it’s not nearly as black and white is one would assume.
For example, if you win $1 million in the lottery and you have a choice of getting a lump sum payment today, or getting the million dollars over a 20 year period, most people would immediately think that taking the million dollars now would be the best option. The problem is that the calculation of the million dollar payout is done over the 20 year period with an assumed interest rate during that time. That means that if you choose to get the lump sum payment today, it will likely be much closer to $500,000 than $1 million.
The key, of course, is the interest rate which is used for the calculation. This varies from lottery to lottery so you will have to know the specifics of the particular lottery to know the exact interest rate. Most seem to fall within the 6% to 8% range. For a more in depth look at this, the StraightDope offers a good analysis of the interest rates. While that’s a pretty good guaranteed rate of return in today’s environment, historically it isn’t the best return that one could expect. You would therefore need to decide whether your own investing could get you a better return than the lottery is offering over that period of time.
In addition to the interest rates, you need to take into account the taxes that will need to be paid on the winnings. This becomes complicated because we know the tax rates today, but we don’t know what they will be in the future. You would need to make some guesses and projections to have an idea of which would be of the biggest benefit. it probably makes a lot of sense to consult a tax lawyer familiar in this area to get all the pros and cons for each choice.
Another key that you need to keep in mind is how you handle your finances. If you are the type who is disciplined and has no problem saving the money, then going after the lump sum payment makes a lot more sense than if you are somebody who spends freely. If you’re the type who spends money quickly when there is money in your account, you’re likely to go through the million-dollar payment extremely fast. In this case it may be wiser to take a yearly payment for 20 years so that the money doesn’t get wasted in just a year or two. By going for yearly payments, you ensure that you will have a good yearly amount to spend for however long the yearly payments are structured.
One aspect that many people don’t think critically about, but should also be taken into consideration, is whether the organization that is making the payments will be around for a long period of time. There are many things which can happen that could make an organization insolvent and not be able to pay the full amount still owed to you. If you choose to take your money in yearly payments, and somewhere down the road something happens so that the company that’s supposed to provide your payments can no longer do it, you’re out of luck and have lost all that money. While this is not likely in most cases, there is always the possibility, and it’s something that should be taken into consideration.
Personally, I think that in most cases it’s probably a tossup to which one is better. I think that your personal spending habits are what would likely determine which would be best for you. If you consider yourself a saver, the lump sum distribution would probably be the better choice. If, on the other hand, you consider yourself a spender, then getting the payments distributed over the 20 year period would probably be the better choice.
As you can see, due to the way the distributions are distributed, it’s not an easy black and white answer. In either case, it probably makes sense that if you find yourself in such a position, you should make sure to talk to a trusted tax advisor to see which one makes the most sense for your financial situation.
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