Lottery winners are faced with the emotional shock of winning life-changing wealth. But it's still important to make smart financial decisions. One key decision lottery winners must make quickly is whether to take a lump-sum cash option or take yearly annuity payments. Mathematical models can give you a precise answer about which you should prefer, but personal considerations also play a key role. Below, we'll consider both elements.
The trade-offs of lump-sum vs. annuity payments
When you take a lump-sum payment, it's typically a smaller amount than the reported jackpot. The reduction includes taxes on the full amount as well as a discount that reflects the fact that you're taking the payment up front. The trade-off, though, is that you get the lump sum all at once. You can therefore use it however you wish right away, either spending it at will or investing it on your own to generate a return.
By contrast, annuity payments will generally add up to a larger amount than the lump sum. Some lotteries set up payments that add up to exactly the jackpot amount, either through equal payments for a period of time or with payments that steadily rise to keep up with inflation. With annuity payments, you'll pay taxes as you go, and since you will receive a smaller amount during each tax year, at least some of the payments will be taxed at lower rates than if you take a lump sum all at once.
Why the smart investing decision might not be your best choice
The primary reason why many financial advisors recommend taking a lump sum is that you can generally expect better returns from investing lottery proceeds in higher-return assets like stocks. In effect, choosing the annuity option is equivalent to investing the lump sum in an annuity, and an advisor can figure out the implied annual return on the annuity option and compare it to a reasonable assumption on what you'd earn on a typical stock portfolio.
Yet even if taking the lump sum makes more sense from an investing standpoint, it might not work for you and your personal situation. Many lottery winners quickly spend through all their winnings, leaving themselves destitute in just a few years. Taking the annuity option gives you a built-in control mechanism on your spending, since you can't spend the money until you get each annual installment. In other words, by voluntarily limiting yourself to taking just a small portion of your total winnings each year, you'll preserve the remainder.
Winning the lottery gives you the opportunity to make some smart financial decisions. Knowing yourself and your habits can help you make the choice that best fits your own needs and interests.
Your financial future shouldn't be left completely to chance; visit our broker center today to get started investing in remarkable companies that will earn you money today and for years to come.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!