The most frequently asked questions from lottery winners and those who just dream about being a winner is:
“Should I take a lump-sum or installments?”
Take the installments!
Despite everyone telling you to take the lump-sum. Your heirs will receive the balance if you die before collecting all the payments and at least 65% of your lump-sum amount will be gone within the first year due to discounting and taxes.
A lump-sum winning will typically get reduced by 45% or more for the time value of money (acceleration by 2o+ years) and then the net amount is further reduced by approximately 35% or more for taxes — leaving a net amount of 35% or less of the gross winnings.
Installment collections will only generally only be subjected to the federal tax hit (depending on state rules) and the taxes are paid over the collection period. In effect, each payment includes a layer of interest earning and once the amounts are received, the recipient is free to make their own investment decision on those funds.
For jackpot allocations under $10 million, a lump-sum might be considered, but in the vast majority of larger prize winnings, installment payments offer significant benefits, including:
- greater income, gift and estate tax planning opportunities,
- significantly reduced income, gift and estate tax rates,
- increased budgeting and retention of winnings,
- reduced probability of family, friends and scammers accessing your winnings.
Following is a summary of the key points to consider:
Up until a few years ago, California Lotto players were forced to make that election at the time they bought their Lotto ticket – which was all the more difficult since the player had no idea of what specific prize they might win (e.g. sole winner, vs. shared prize, etc.). Now both SuperLotto and MegaMillions winners can make the election within 60 days of winning – so there is time to evaluate options. The default payout if no election is made is a 26 year payout.
Installment payouts are made annually over a 26 year period beginning at 2.5% of the gross Lotto prize and then increasing to 5.1% in the 26th year. And despite general confusion on this issue, if you die before receiving your entire payout, your heirs are entitled to receive it – unless the Sacramento legislators decide they might be more worthy recipients.
For a number of economic and tax reasons, my advice for the vast majority of taxpayers winning more than $10 million dollars is to take the winnings in installments.
There are a couple of negatives to installments:
1) If interest rates and/ or tax rates jump up, having your pay-out locked into an annuity format may work against you,
2) If the winner (and their spouse if married) pass away during the first few years of the payout, a large estate tax obligation may materialize before funds are accumulated. Life insurance and loans may be structured to mitigate this issue.
The first advantage of an installment payout is saving yourself from the grief of the double-whammy of:
- A “present value” discount from the state of 45% to 55% off the jackpot winnings to take into account the fact that the state is accelerating the payments for up to 26 years. Therefore a $100 million jackpot becomes a much less exiting $50 million (before taxes).
- Some good news – the state does not tax the Lotto winnings (but will tax interest and dividends earned on your winnings). However, the IRS will withhold at least 25% in taxes (applied after the present value discount) before you get your net check. Now the $100 million is sitting at approximately $37.5 million ($50M x 75% after-tax). And things will get worse when you end up paying another 10% ($5 million in this case) or more in federal taxes when you file your return for the year you won – since the maximum federal rate is 35% and the IRS may have only withheld 25%.
1. Since the vast majority of winners end up blowing most or all of the money for a variety of reasons, electing installment payments forces discipline for the winner to preserve their winnings and not go out on a spending (and/or giving) binge – although even an installment winner can accumulate large mortgages and other debt.
2. Another advantage of installments is effectively locking into a guaranteed rate of return on the deferred winnings. The specific rate of earnings is dependent upon what the bond market yields are at the time the state purchases the underlying bonds to support the payout. Therefore, current investment yields will be less than a few years ago. The downside of locking into an installment payout is that if rates rise or you believe you can consistently make better investment decisions, a lump-sum payout will give you that option – but be forewarned your investable to secure future investment earnings will be a fraction of what it is by leaving the winnings in the installment form.
3. If the above reasons are not enough, then another huge advantage of the installment option is the ability to apply long-term tax planning to your new-found wealth. For example, if you receive a net $50 million in 2010, there is not much you can do to shelter such a large amount of money in a single year. However, if you receive $2.5 Million to $5.1 million per year, which would be the case for a $100 million winner, there are various legitimate ways to mitigate the annual tax bite by offsetting the annual payments with retirement plan contributions, possible operating losses from active businesses the winner may be involved in, as well as mortgage interest, property taxes and charitable contributions. While full sheltering will seldom be possible on large winnings, a material reduction in overall tax liability is often possible. Even with likely rising tax rates, having time to implement these strategies is well worth the exposure to (future) higher tax rates.
4. Many families and some groups of employees have a history of playing the Lotto under a verbal (or in rare cases written) agreements to split winnings amongst participating members. The conclusion as to whether there was a pre-arranged “partnership” to share the winnings is very fact specific, but the courts routinely uphold these verbal arrangements to split winnings. This can offer very significant income, gift and estate tax advantages within a family unit – but can also raise huge issues within the family or co-worker ranks. Depending on the size of the group and the amount of the specific Lotto prize awarded, a determination can be made whether the installment method or lump-sum makes the most sense for the group or specific winners. This can get complex and it is unclear which specific fact patterns the Lottery Commission will honor and when “master” elections and “sub-elections” can be made by the winners.
5. There are numerous issues (including pre- and post- win residency status, estate and gift planning, verbal contracts, etc.) which arise for these lucky winners and before too many promises and plans are made, before claiming the prize and making the lump-sum or installment election the winners should contact a qualified attorney, investment adviser and tax adviser and meet with them as a group to insure that all the options and complexities are fully evaluated.
For daily tax and financial updates, please follow me @: www.twitter.com/taxcredits_cpa
