Lottery winners can receive their prize in one lump-sum payment or through an annuity that provides annual payments spread over a long-term period. There are pros and cons involved in either choice.
Before lottery winners can collect their jackpot, they must usually make one important decision: do they want to collect their winnings all at once or over a long period of time?
The first option is called a lump-sum award, when the winner receives all of the lottery winnings after taxes at one time. The second option, to enter into a long-term payment agreement, is called an annuity. Annuities allow recipients to receive a stream of periodic disbursements from an account created by their state lottery commission.
Each state and lottery company varies. Powerball, for example, offers lottery winners the choice of a lump-sum payout or an annuity consisting of equal annual payments over 30 years. Mega Millions offers lump-sum payouts or annuity payments that increase by 5 percent each year over a 30-year period.
While both options guarantee a lottery payout, the lump-sum and annuity options offer different advantages. Choosing a lump-sum payout can help winners avoid long-term tax implications and also provides the opportunity to immediately invest in high-yield financial options like real estate and stocks.
Electing a long-term annuity payout can have major tax benefits.
Depending on the amount of the winnings, individuals who choose annuity payments over the lump-sum payment can fall into a lower tax bracket. They may also be eligible to receive a larger payout in the long run. A 2013 lottery winner was awarded a $400 million Powerball. After taxes, the final amount would come close to $242 million awarded in smaller increments of about $7 million a year for 30 years. If the winner were to choose a lump-sum payment, after taxes they would receive about $135 million.
There are also a number of risks associated with each type of payout. While a lump-sum option can provide immediate monetary gratification, receiving a large amount of winnings all at once can influence lottery winners to make extravagant purchases or poor choices. Winners who are financially illiterate may squander their funds all at once or not invest it properly, leading them to bankruptcy or financial loss. After winning $170 million in 2002, one lottery winner was robbed repeatedly. In another example, a $5 million lottery winner from 1981 now lives on his pension as a result of several divorce settlements.
Another downside of an immediate influx of cash is that the actual payout is significantly less than the amount won in the lottery. For example, when three Powerball winners split a $448 million prize in 2013, they didn’t individually collect a third of that jackpot (roughly $150 million per person). Instead, the federal government first applied its tax rate of 39.6 percent to the winnings, and there were state taxes. With a long-term payout option, the three Powerball winners would have been able to pay taxes gradually, allowing interest to accrue on their winnings. In the end, each winner in this example was left with about $90 million.
Like the lump-sum option, a long-term annuity payout has its own set of drawbacks. Perhaps a lottery winner wishes to live free of debt or wants to pay for college tuition, but cannot achieve that goal due to smaller periodic payments. Unlike a lump-sum payment, a long-term annuity can be inflexible, prohibiting the winner from changing the payout terms in the case of an unexpected financial or family emergency.
Taxes also influence many lottery winners’ decisions on whether to choose a lump-sum payout or an annuity. The advantage of a lump sum is certainty — the lottery winnings will be subjected to current federal and state taxes as they exist at the time the money is won. Once taxed, the money can be spent or invested as the winner sees fit.
The advantage of the annuity is the exact opposite — uncertainty. As each annuity payment is received, it will be taxed based on the then-current federal and state rates. Those who choose the annuity option for tax reasons are often betting that tax rates in the future will be lower than the current rates. However, should they regret their decision in choosing an annuity payout, lottery winners do have the the option of selling their annuity payments for a discounted lump sum.
If you are interested in selling some or all of your annuity payments, you should contact your lottery company to clarify if the annuity can be sold. Many lottery winners who decide to take the annuity have an option to cash in that long-term investment.
There are currently 28 states that allow after-market sales of lottery annuities for a lump-sum payment.
Winners also can decide to sell all or part of their future payments. The terms of the sale, including the total amount, are up for negotiation. In addition to funding an emergency expense or paying off debt, many seniors also sell their annuities because it is illegal to transfer annuity payments from a living winner to anyone else. But, a lottery jackpot can be disbursed to a group of people.
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As with transferring payment rights under the provisions of a structured settlement for personal injury, the winner must have court approval for the transaction to take place. A judge makes the decision whether such a sale is in the person’s best interest. Some lottery companies only allow for a transfer of the funds when the annuity owner dies. In this instance, any remaining assets will be disbursed to a living beneficiary until their death or the end of the contract.
Lottery winners who decide to sell their periodic payments for a lump-sum payment must first learn if they are allowed to do so. That is often determined by the state in which the lottery was won and not by the state in which the lottery winner lives. Sometimes there are ways of finding a loophole, a task best suited for a personal attorney.
Typically, two types of companies purchase long-term lottery payouts: factoring companies and insurance companies. These are the same companies that purchase settlements from sellers who collect personal injury settlements and other kinds of long-term payouts.
Someone who cashes in some or all future lottery payments will owe federal income taxes, and in some instances state income taxes, on the amount of the lump-sum payout. The tax rate will be the ordinary income tax rate. This differs from someone who sells a structured settlement gained from a personal injury lawsuit. In those cases, buyouts are tax-free.