After Winning the Lotto, Should You Take the Cash Value or Annual Payments?

So, you won the lottery, now what?  Well, there's lots to do.  Build the barbed wire fence around your home, start digging that moat, change your phone number...  Busy times for the newly wealthy!

Before you do any of that you have one important decision to make.  Probably the most important one you've ever had to make.  Do I take the cash value today or should I take the annual payments?  let's run the math.  Each state may be a little bit different, but the California Lottery gives the option of a cash lump sum that they estimate at around 45-55% of the jackpot amount.  If you select the payment option, you will receive an increasing payment over the course of 26 years.  The first payment will be 2.5% of the jackpot, increasing to the 26th payment of 5.1% of the jackpot amount.

They give a sample payout of a $7 million jackpot, which is the lowest jackpot possible in the California Super Lotto.  Their site goes so far as saying, "these payments would gradually increase each year until the final payment of $357,000 - a 100% increase over the first payment!"  Like it's a good thing that you get more of your money later than sooner.  What again is the first rule of Time Value of Money?  Oh yea, money is worth more today than tomorrow.

Based purely on the math, which one should you pick?  Well, their range of 45-55% for the cash value complicates things a bit.  But here are the calculations.  If the cash value is 45% of the jackpot, the Internal Rate of Return (IRR) on the payments (the return you would effectively receive on your stream of payments) is 6.17%.  If the cash value is 50% of the jackpot, the IRR on the payments is 5.24%.  If the cash value is 55% of the jackpot, the IRR on the payments is 4.43%.

In other words, if you think you can generate a return higher than the respective IRR, you should, based on the math, take the lump sum.

But it's not that simple.  We have all heard stories of people winning the lottery and within a few years find themselves divorced, friendless and broke.  Can you handle that sort of money all at once?  I think most of the people reading this fall in the camp of "yes, I can handle it" and truthfully can.  I believe that the majority of people cannot.

The majority of people would have a difficult time with that sort of money, and will be susceptible to scams, poor investments, wild spending or over gifting or lending to friends and family.  Here's where you throw the math out and consider the psychology.  Most people want an income.  Not an asset or a business, but an income.  The payment stream gives them that.  In the California Lotto example the first year's payment would be $175,000.  Let's say they blow through it.  Wild trips to Vegas, new car, etc.  Worry not, they have $189,000 coming next year.  Now let's say they blow that in gifts and loans that will never be repaid.  Well, year three they get $196,000.  That one disappears with the scam artists.  At some point, I have to believe that this person is going to figure out how to actually get some decent help, and take care of that money.  With a lump sum, he has one shot.  Blow it and the money is gone.

So, I'll probably take the cash value when I win.  If you asked me what you should do, I'd probably tell you to take the payments.

By the way, here's my simple spreadsheet that breaks down the IRR: Download lotto_irr.xls

 

Comments

[financial freedumb]

"So, I'll probably take the cash value when I win. If you asked me what you should do, I'd probably tell you to take the payments." Haha...Thanks.

I did read this too though, "I think most of the people reading this fall in the camp of "yes, I can handle it" and truthfully can." :)

I think I'd take the lump sum...By myself a few houses and businesses to generate $200K+ a year of income.

Actually, I thought about it...I would do this:

20% would go to some sort of liquid investment like stocks or CDs.
20% to business and housing investments
20% to family
10% to friends
20% to myself
10% to charity (humane society, schools, and a couple others)

The 20% for myself I'd use to buy a house, car, and a trip to Vegas. Ah if I actually won it, I'm pretty sure everything I "planned" would be out the window...maybe I will take the payments.

[frankyj]

But even if you don't take the cash option, there are still companies that will sell you a cash value for your annuity stream. Isn't capitalism grand :P

[Tim MMF]

I would take the cash value up front because I could put it to work for me and make more than the annual payment. Also, if you were to die while collecting the annual payments the balance goes unclaimed. But with the cash value you can leave it for your family.

[Anon]

The lump sum would be taxed almost entirely at the top bracket, while the majority of the individual payments are subject to lower brackets every single year. This is a non-trivial difference.