Lottery fever remains at a high level lately, thanks in part to jackpots that sometimes exceed $1 billion, including the $1.334 billion Mega Millions winning ticket sold in July to individuals in Illinois, who claimed the prize via an anonymous partnership. They opted for the lump-sum amount.
While those winners chose the lump sum, if a newly wealthy winner comes to you for advice about how to receive the windfall, we strongly recommend carefully evaluating the installment option before claiming the prize.
Installment vs. Lump Sum
Most lottery winners elect the lump-sum option, and their reasons for making this choice are often erroneous. Many believe that installment payouts stop if the winner dies. This is not true. Or they fear the state and/or lottery commission could go bankrupt before they are fully paid out. This is highly unlikely since the installment obligation is backed up by a “laddered” bond portfolio. Other concerns include higher tax rates and/or high inflation in the future — which are valid concerns that should be factored into the analysis.
Taking the lump-sum option on a multimillion-dollar prize is usually a poor decision, partly because winners will take a permanent net-present-value haircut of 30% or more on their payout, plus pay 100% of the tax in the first year of winning.
To explain further, the advertised winning amount is the pretax payout over several decades, often 30 years. By patiently waiting for their annual installments, the winner(s) will receive the full advertised winnings. By electing a lump sum, on the other hand, there will be a time-value-of-money discount, which generally falls in the mid-30% range but can be as high as 39%. (This discount decreases with larger prizes, since a smaller annual return is required to compound the lottery commission’s initial investment and increase to the full prize. Due to the record amount of the recent Mega Millions award, the actual discount rate on the lump-sum payout reportedly dropped to a record low of 17.65%, which may have factored into the Mega Millions jackpot winners’ decision to take the lump sum.)
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