Written by: Phillip Tew, Ph.D., J.D.
The current Powerball jackpot (up to $1.5 billion as of January 13, 2015), has caused a growing number of individuals to ignore the odds against them (more than 1 in 292,000,000) and purchase a ticket with the dreams of hitting it big. While most of the participants’ dream of vacations, new homes, and new cars, it would be worthwhile to look at the financial aspects of winning big!
Lump Sum vs. Annual Payments
Assuming that you win the $1.5 billion jackpot, the first question that you must answer is whether you would prefer a lump sum payment or a series of equal payments over time (an annuity). Currently, if you choose the lump sum amount you will receive $930 million dollars (before taxes are paid). If you choose the equal payments, then you will receive approximately $50 million immediately (before taxes again) and then 29 additional payments each year (the payments rise slightly to account for inflation in certain lotteries but not in all of them). So which is better? The answer comes down to one major question, and one minor question.
Return on Investment
First, the major question – what return can you earn on your investments? This is the primary driver as to which option to choose. From 1928 – 2015, the US stock market has had an average return of 11.41%, while the US Treasury Bills have had an average historical return of 3.49%. In regards to the current set-up of the lottery system, it is a better financial decision to take the lump sum amount of money if the winner is able to earn a return greater than 3.411% for the next 29 years. This information along with the historical averages seems to imply that one should always take the lump sum amount. It should be noted that from 2002-2015, the US Stock Markets had an annual return of 4.75% and the US Treasury Bills only returned 1.8%. Many behavioral finance experts argue in favor of the annuity to save the winner from his or her own self – not being able to blow it all within a couple of years. Prior research has shown that bankruptcy rates among lottery winners increase dramatically three to five years after winning the money, and other research has shown that the winners typically save only $0.16 per dollar won.
The minor question is asking yourself if you believe that tax rates will be changing drastically in the next 29 years. For 2016, the top tax bracket will be 39.6% at the federal level. Assuming you are an Arkansas Resident (with a 7% maximum income tax bracket), then requesting the lump sum will result in an actual payment received by you of approximately $496.6 million, versus the periodic payments which will initially be $26.7 million. If you expect tax rates to drastically rise, then it would be in your best interest to take the lump sum prior to the tax increases.
Spending Your Winnings
Now that you have decided which option to take, your next decision is – what to do with the new found wealth! Financial planners agree that the first step is to always pay off all debt immediately. The next step is to sit down and list your financial goals and rank them by importance (for example – have a vacation home, buy a new vehicle, take a cruise, be able to retire at age 50, etc.). Getting an accurate cost for these goals and comparing it to your new found wealth is the next step. Finally, determining how and where to invest your remaining funds is the crucial final step. Investment planners, Certified Public Accountants, and Certified Personal Financial Planners can assist with these issues.
And when making your financial plans, don’t forget your friends at Arkansas State University!!