Is the Lump-Sum or Annuity Payment Better When You Come Into Money?

After years of faithfully scratching off your ticket or picking your numbers down at the Quick-E-Mart, you have finally struck it rich! You watched the numbers on TV, triple checked your ticket and cross-referenced with another source. You have won the lottery! Perhaps you have the choice of a lump sum payment or annuity from a less pleasant source-an accident settlement of life insurance payment. Either way, you have a decision to make: lump sum or annuity. For the sake of keeping upbeat, I'll focus on the lottery jackpot.

First, let's say that your jackpot was, say, $10 million. If you read the fine print, the $10 million is an annuity value-meaning the sum of all the payments you receive will be $10 million. Lottery regulations vary state by state, but typically you can expect to collect 60% or so, before taxes, if you elect a lump-sum disbursement. This is because a dollar is worth more today than it will be in the future-the economic concept of time value of money. To wrap you mind around this, think in terms of a gallon of milk. Fifty years ago it might have cost around twenty-five cents. Today it is four dollars! One dollar would have bought you more milk fifty years ago than today, so the value of your dollar decreased over time.

Your state lottery commission will give you the option to receive annual payments of $500,000 a year for twenty years ($10 million total) or a lump sum of around $6 million. At first, you might say "Woo hoo, $10 million is more than $6 million!" and take the annuity, but there is more to be considered.

For my example, we will ignore taxes, but I don't recommend this in the real world. We'll also assume that you quit your job because I'm a realist and I would too, and you allot $100,000 a year for your budget. Finally, we'll assume you invest your money conservatively with an annual rate of return of 5%.

With the annuity, you're getting paid $500,000 a year and spending $100,000 of that, leaving $400,000 a year to be invested with a return of 5%. At the end of 20 years, you should have around $13.2 million in the bank. Not bad at all!

If you take the lump sum, you'll have $6 million in cash up front. Five percent ROI will earn you $300 thousand in interest your first year. At the end of the same 20 year period, you should have around $15.9 million-a cool $2.7 million more than taking the annuity.

Let's say you invest the money a little more aggressively and earn a 9% return over those 20 years. You'll end up with $20.6 million and $33.6 million, respectively. You can see the difference here is $13 million dollars! The investment income for the first year will be $540,000-more than your annuity payment, plus you have a cool $6 mil in the bank.

So, based on this illustration, you'll be much better off taking the lump sum. But, there are variables. First, discipline. If you have a check for $6 million, can you invest it without buying cars, houses, or even tropical islands? The second thing we totally ignored is taxes. Our Uncle Sam is a fickle man; a tax professional should be consulted to fully understand how deep he will get into your pockets. Finally, investment return. We have no way to accurately predict the investment income your windfall will produce over 20 years. Because of the variables, it is a difficult issue to decide; but, it's certainly not as simple as choosing the annuity because it pays $10 million versus $6 million for the lump sum.