|Posted: February 17, 2003, 6:04 am - IP Logged|
If you win lottery, take lump sum and investBy RONALD LIPMAN
Q. Every time I buy a lottery ticket, they ask me whether I want the cash option or they simply assume I want the cash option. Apart from getting more money right away, which is financially smarter: taking the smaller amount now or taking the periodic payments?
A. The cash option is the way to go for most people. Here's why.
If you choose the annual payments, 1/25th of the total jackpot will be paid to you once a year for 25 years. If you choose the cash option, you will receive a lump-sum payment that is equal to what someone would pay you today for the right to receive those 25 equal annual payments.
With interest rates and market returns as low as they are today, taking the cash option should yield a relatively large payout.
Why? If you think about money you have in the bank today, one of your dollars will take an extremely long time to double in value, given the historically low interest rates currently being paid by banks. But if you could earn an 8 percent compound return on your money, a dollar could double in just nine years. When interest rates and market returns are low, it takes a larger lump sum to earn enough to make the same series of payments over a multiyear period.
In the financial world, a series of 25 equal payments is called an annuity, and it's fairly easy to value. In fact, the way the Texas Lottery figures out how much to pay you if you choose the cash option is by seeking bids from a preapproved list of investment firms to see what the cheapest cost would be for a 25-year annuity. When the investment firms make their bids, they're taking into consideration the low returns today, but they're also assuming interest rates and returns will rise over the next 25 years. A highly optimistic company will charge less today for a 25-year annuity.
So, if you win a $25 million lottery, and one company says they would take $13 million dollars today to pay you $1 million a year for 25 years, but another company says it would take only $12 million, how much do you think you'll be receiving as your lump sum payment? You guessed it. Only $12 million.
There are a few situations where taking the annual payments make sense. One is if you are the kind of person who likes to spend, spend, spend. If you have trouble saving money, you might be better off taking the 25-year payout. That way, you'll basically be putting yourself on an allowance. If you happen to blow through an entire year's payment without saving a dime, you'll be given a fresh start the following year.
But remember, $100,000 today is not the same as $100,000 in 25 years. Think about what new cars and homes cost in 1978. If you take the 25-year payout, you need to consider that inflation will be causing the products you purchase to increase in cost, and the purchasing power of the money you'll be receiving two decades down the road will be far less than today.
And what if there are a few years of hyperinflation during your 25-year payout? The real value of your fixed payments could drop significantly. That's as good a reason as any to take the money as a cash payment. If you have the money in your possession, at least you can invest it at a rate that keeps up with that hyperinflation.
You might also want to take the annual payments if you are currently earning little income, and the jackpot is not too large. For instance, if you win a $4 million lottery, you may be better off taking 25 payments of $160,000 each year, rather than one lump sum of about $2 million, all of which will be taxed in a single tax year. In 2003, the highest bracket is 38.6 percent, and it kicks in at $311,950 of income. By taking payments over 25 years, you will lower your income tax liability about 10 percent, based on today's tax rates, because you'll be earning less money each year.
On the other hand, if you are lucky enough to win a lottery so large that each of your annual payments will be $1 million or more, then you will not save as much income tax by taking your winnings over 25 years. Similarly, if you are already earning several hundred thousand dollars a year and your earnings will not drop even if you win the lottery, then receiving the payments over a 25-year period will not materially reduce the amount of income taxes you must pay.
You also need to think about your age. If you are older, you may not have 25 years left to enjoy all those payments. You may think it's best to take the cash option and spend the money as fast as you can.