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When Selling Lottery Payments, Consider the Interest Rate

In a typical state lottery, the cash value is roughly half the face value. This is because modern lotteries involve a bit of financial sleight of hand. You’ve “won” $X million only in the sense that you’ll receive that much if you’re willing to wait 20 years to collect it. What you’ve actually won is a lesser amount of cash, plus the interest that will accumulate on that cash over the course of the payment schedule.

The assumption underlying most periodic lottery payments is that money is constantly productive – that is, there is a time-value to money, represented mathematically as the interest rate. The interest rate is critical in determining whether a lump sum is a better deal than periodic payments.

Let’s say you win a jackpot of $1,000,000 from the California lottery. The lottery rules say that total will be paid out to you in 20 equal annual payments of $50,000 each. Alternatively, you can take the lump sum cash value, which is about half the face amount – about $500,000. Which should you take? To find out, you need to determine what interest rate you’ll be getting with the annuity. Punching a few numbers into a calculator, you will find that if you start with a cash value of $500,000 and expect to wind up with $1,000,000 after 20 years (in other words, the equivalent of a $50,000 annuity), the underlying annual interest rate has to be 8.92%.

So, in this case, choosing the periodic payments option is the best deal – you simply cannot find a guaranteed 8.9% annual interest rate for the next 20 years anywhere else.

Consider Your Personal Circumstances

Real life, of course, is much more complicated than simple math. That’s why it’s important to weigh your personal circumstances and preferences when making your decision. For instance, if you win $1,000,000 at age 75, you may not want payments over 20 years; you might prefer to sell your lottery payments and have the lump sum of lower current value to use now. On the other hand, if you’re afraid that your kids would blow it when it is time to move the estate, you might prefer the discipline of periodic payments.

Consider The Tax Rate, Too

When deciding whether or not to sell lottery payments, you also need to consider the tax treatment. Normally, if you are able to choose the form of payment (i.e., lump sum vs. periodic payments), you are immediately taxed on the entire sum. This is called the doctrine of “constructive receipt” – if you have any control whatsoever over the form of payment, the government taxes you all at once. Thus, taxes would be the same whether you chose to sell lottery payments or not.

However, state lotteries have a way to circumvent this. When you purchase your ticket, you can sign an irrevocable agreement asking for an annuity. You no longer have a “choice” of how to take your winnings, so the tax treatment is different.

Normally, tax on an annuity will be less than that on a lump sum because of the lower rates on lower income brackets. However, if you choose this option, you’re taking a gamble that tax rates will remain the same throughout the course of the payment schedule, and any future change in tax rates could distort your calculations.

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Visit www.woodbridgeinvestments.com for more information on selling structured settlements and annuity payments.