If you win the lottery, are the beneficiary of a trust or settle a large lawsuit or insurance claim, you may be faced with the choice to take your reward as a single large sum of money or as an annuity that pays a series of set annual payments. Pocketing millions of dollars at once can seem attractive, but regular sums for years to come may be more manageable. Both options have advantages and disadvantages. Your tax situation, goals and even your personality help determine the best choice for you.
You’ve seen the billboards advertising lottery jackpots – $6 million! $3.2 million! $54 million! This represents the total amount you’d receive if you elected the annuity option for your payout – an annual payment for a set number of years. The same can be true of an insurance settlement. The total reward quotes represents the present value of the reward, with interest for each year of the annuity. If you take the lump sum, you’ll receive the present value of the reward, without the interest. This usually adds up to a little more than half the amount of the total payments with interest. This is a before-tax number.
You’ll owe 35 percent of any large cash reward, such as lottery winnings, to the federal government – 35 percent is currently the top tax bracket for ordinary income, which includes lottery winnings. If you receive an award as part of an insurance settlement or as the results of a lawsuit, the money may or may not be taxable. Check the terms of the settlement to find out. If the money is taxable and you live in a state with a state income tax, you’ll also owe that tax. Most payers withhold the tax before they make the payout, but the federal government only requires them to withhold 25 percent. You’ll still need to keep back another 10 percent to pay come tax time. While you can make charitable donations and set aside part of the money in a retirement account, most people have a hard time making enough donations and setting aside enough money to reduce the tax burden of a significant payment. If you decide to take the annuity, you’ll pay taxes on each year’s winning. It’s easier to shelter smaller amounts to reduce your tax bill, but if tax rates increase over the life of your lottery annuity, you’ll owe a bigger chunk of money to the government.
Advantages of Lump Sum
Choosing the lump sum option allows you to invest the money as you choose, and to potentially earn a higher rate of return than you’d realize taking the annuity option. Some people prefer to have the money now rather than trust to an uncertain future – though if you die, the annuity usually continues, collected by your heirs. Check the terms of your settlement to verify this. If you’re able to control the urge to blow everything now, you can manage the funds as you wish. Inflation doesn’t lower the value of your winnings as severely as it can the annual payments – for instance, if you elect to receive payments of $200,000 a year for 26 years, that $200,000 will not have as much purchasing power in 26 years as it does now.
Advantages of Annuity
If you like the security of knowing you’ll be getting a sum of money every year for years to come, the annuity option should appeal to you. Even if you blow all the money you receive the first year – as many lottery winners do – you have more money coming. Taking the annuity gives you more options for lowering your taxes. Also, as you gain investing knowledge and settle into your new lifestyle, you have more time to ponder your investing options for each annual payment.
- BananaStock/BananaStock/Getty Images