Invariably, when someone wins the lottery, the options go something like this:
The Jackpot is $1 billion. If you take the lump sum, you get $600 million. If you choose annuity, you get twenty payments of $40 million each, adding up to $800 million. (figures pulled out of thin air)
Obviously, there is meant to be some incentive for people to choose the annuity (or conversely, a penalty for taking the lump sum, if you put it that way.) But what’s the purpose or intention of such?
I don’t think it’s an incentive for the winner to pick the annuity option so much, as it’s financially better or more feasible to the payout entity to pay in annual installments. So taking the lump sum comes with a penalty. That’s what I’ve always assumed, anyway.
I don’t think the lottery cares whether you take the annuity or cash. The present value of the annuity is equal to the cash value of the prize. The annuity option is higher because the lottery commission can invest the lottery amount, earn interest, and pay extra money to the winner over time. The annuity option allows the lottery commission to advertise a higher jackpot than just the cash value. But offering the cash value convinces some more people to buy a ticket when they don’'t want the annuity, so the lottery offers both.
It has to do with interest and the present value of money. There is a formula that says at this interest rate I can invest $X now and pay out $Y per year for Z years. That $X is the cash value you get paid out.
If you think you can invest your money better than the lottery, or you think interest rates will change, or you need someone else to control your financial responsibility, etc. would determine whether or not you should take the cash now or the annuity.
What happened to the other $200 million? Did it go back into the thin air? Usually the jackpot number is just the sum of the nominal value of the annual payments, right?
But anyway: The state generally offers you the actual present value of the annuity as a lump sum. No incentive either way without speculating about lots of future unknowns.
Using your numbers as an example, if you went to an insurance company and said “I want to get paid $40 million a year for the next 20 years”, they’d say, “Sure. That’ll be $600 million”.
I believe a certain amount goes towards funding schools, etc. At least here in Texas, that’s a commonly-touted point about lotteries - “you’ll be funding schools on the side by buying tickets.”
ding ding ding!
In the US, you pay taxes on lottery winnings, regardless of whether or not you take the annuity. I’m sure there are some tax shenanigans you could get up to with either option, if you looked into it.
Sure, but that amount comes out of the ticket sales, not the advertised jackpot total.
Plus, the annuity is calculated to be worthwhile based on a certain fixed interest rate. If the lottery commission can get a return on investment better than the one conceded to the winner (i.e. if interest rates rise over time?) they come out ahead.
I assume any annual payout probably puts you into the top tax bracket regardless ($400,000-plus?). Your savings would be the taxes on what, the lower rate on the first $400,000 each year? If you invest, instead of blowing the whole billion in one year, odds are your income will exceed that $400,000 for the next 40 years anyway.
The real question is - can you get better returns investing, than the rate the lottery commission is offering in their calculation? (What rate do Powerball and such offer?)
Let’s say you win 25 million in the Powerball lottery, for a nice round, non-absurd lottery jackpot.
Your cash value would be something like 11 million after Federal tax. All yours, up front.
The annuity would pay out something like $285k the first year, and growing by 5% per year, until the thirtieth year, at which point your last payment would be $1.17 million. But the catch is that at the end of that 30 year period, you only have the total payout- $25 million.
The cash value option gives you the option to say… buy a 5 million dollar home outright. Or start a company, or whatever, and isn’t limited to the $285k up front, or $300k the second year.
And, if you just invest that initial 11 million and make 4% (lower than the historical average), you’ll dramatically outperform that annuity- ending up with about $32 million at the end of that time.
The annuity only makes sense if you’re a spendthrift, completely ignorant about financial matters, or don’t care about actually making money on your winnings.
And it’s an easy way for them to advertise bigger jackpots like @Tired_and_Cranky points out- they can take $11 million, invest it in an annuity that’s essentially foolproof, and pay out $25 million over 30 years. So they advertise a $25 million jackpot because it looks more sensational than $11 million up-front.
When the state lotteries started up in the U.S., the prizes for their big games didn’t typically have the “lump sum” options – they were mostly, if not always, paid out over years. (The guy who was my boss at my college work-study job won the Wisconsin Lottery’s big weekly game around 1990; at that time, the only option was 20 annual payments over 20 years.)
At some point, many of the lotteries, including the multi-state Powerball and Mega Millions, started offering the lump-sum option. As noted above, they still advertise the larger number, which comes from the annuity-style payment, because it’s a bigger number.
Yes, at least here in CA, you get the full amount (less taxes) if you go for annuity, and half if you cash out.
The annuity is a good idea. Too many Lotto winners spend their windfall poorly, or get scammed.
Well, yeah, but then it would be Cash= $300M, yearly $30M over twenty years.
And if the jackpot winners in those days “needed cash now” , well, that’s why places like JG Wentworth exist and you can still use them if you choose the annuity. Although since they need to make a profit, they will offer you less than the lottery would have given if you chose a lump sum payment to begin with.
For a full discussion of present value, future value and annuities, as usual Investopedia has a great article.
One warning in case you win and choose the annuity option is that if you die before receiving the last check, your estate owes taxes on the remaining unpaid amount.
Some years ago, I ran the numbers. The cash option and the annuity option had the same net present value at about a 6% interest rate.
In those days, you could easily get 6% from a passbook savings account, so the cash option was usually the better deal.
Then came the 2008 financial crisis. Since then, the Fed has been artificially suppressing interest rates. Unless you are very confident in your investment skills, the annuity would probably be better for most people.
Now that interest rates are expected to rise again, the pendulum might swing back.
Yes, the cash option of recieving half of the jackpot value is there because half of the advertised jackpot is all that the lottery people actually have.
If the jackpot is 10 million dollars they do not really have 10 million in the pot, they only have 5 million. So they are adveritsing a jackpot twice as large as the money they actually have. False advertising of a sort.
If you go with the annuity, they will invest that 5 million and pay you in incriments over usually 30 years. If you go with the cash option, here is your 5 million dollars to invest on your own.
At no time did the lottery ever have 10 million.
Then if they’re banking on investments, what if the economy goes awry and all their investments tank? Do they get off the hook for not giving you your annuity money?
Or are their investments in things so safe that they can’t go down?