So I win the lottery . . .

Hypothetical question: I win the California State Lottery Super Lotto Plus drawing, let’s say the payout is $50 million, and I’m the only winner that drawing.

Do I select the “26 annual payments” option or the “cash value 1-time payment” option? Which should I choose to maximize my investment potential (i.e. never have to go to work again)?

Some notes:

The cash value option is explained by the following from the CA state lottery website: “If you mark the Cash Value box, and you win, you will receive the estimated present cash value of the announced jackpot in one lump sum. This amount will be less than the announced jackpot. For example, if the announced jackpot is $7 million, the winner would receive about $3.2 million in one lump sum. This example is based on the average market cost, as of June, 2000, of 26 annual payments funded by the U.S. Treasury Zero Coupon Bonds.”

The 26 annual payments option changes the amount each year. The first payment is 2.5% of the prize, every year it increases by about 0.1%, until the 26th payment is 5.1% of the prize.

(CA state lottery info: http://www.lottery.ca.gov/games/superlottoplus/paymentoption.asp)

Obviously, there are factors such as inflation, changing tax rates, rate of investment return . . . any others?

One other factor I can think of. If you take the lump sum, you’ll pay taxes on it all at once. That means you’ll have less than the original sum to invest and, accordingly, your rate of return will need to be higher. If the state invests it, you’ll pay taxes only on what you receive that year (the interest). Therefore, your entire principal will be invested.

So it comes down to whether you think you can beat the rate of return with $3 million-something invested in U.S. Treasury bonds, vs. what you’d choose to invest your somewhat less than $3 million in.

Basically the state is getting its money one way or the other. This is how they make money on lotteries. They figure in order to pay out $50 million in 26 years they need to buy $23 million in Treasury Bonds. They get to keep the other $27 million and do whatever they want with it. If you take the lump sum they simply figure this out and keep what they want.

Theoretically the 26 payments could be better or worse depending on which way the economy goes over that time. Since there is no real way to be able to tell what would happen I’d say it’s best to take the money and run. You’ll have many more options in investing with a big pile at once then lots of little piles over 26 years.

I also heard (and don’t know if it’s true) that the 26 year payment is an annuity that is not considered as part of your estate. So, if you die after say one year your family does not continue to collect the payments. It is for this reason that many people incorporate themselves as a business and cash the winning ticket as a business. That way even if the original person died the business is still around to get paid (so your heirs are taken care of).

In either case you win only the cash value amount. The Lottery Commission is giving you the choice of taking it now “as is” or letting the Commission invest it for you and pay it out, principal and interest, over a 26 year term.

Consider this - an investment earning a return equal to 8%, compounded, will double it’s value in about 9 years. That means in 26 years your $3.2 million would be worth about $12.8 million. Invested by the Lottery Commission over the same term it would be worth $7 million.

The questions to ask are these:

  1. Do you think that by investing the money yourself you could beat the ~4% annual return that the Lottery Commission guarantees?
  2. Are you willing to accept the risk associated with investing yourself or are you more comfortable with the guaranteed (but lower) return?

If your answer to both is “yes” go with the cash option. If the answer to either is “no”, go with the annual payments.

FWIW, they don’t do it that way in California. From the CA web site:

"What happens if a winner of a prize paid in installments dies before his or her last installment has been paid?

The California Lottery® prize is the winner’s property and is considered part of the winner’s estate. The winner may will the prize or leave it in trust to designated heirs. The California Lottery encourages all winners of large Lottery prizes to consult with financial experts to review their options."

I’m not positive but I believe that $3.2 million puts you in the top tax bracket and certainly a one-time payment of ~$23 million would as well. Either way you are going to get hammered by taxes and (assuming the rate stays constant over the 26 year period) I think the end result would be about the same.

What I always thought sucked about this is if you try and spread the winnings around to family and friends. Say you win $50 million, take one lump payment for $23 million(?), get taxed at 45%(?) on that and walk home with ~$12.5 million (basically only 25% of what you supposedly won).

Now, say you want to give a million to mom & dad and million each to you 3 brothers and sisters. This money has already been taxed but I think your mom & dad and siblings would have to pay income tax on that money as well so they each walk home with ~$600,000. That amounts to a nearly 60% tax rate on each million you gave away.

Don’t get me wrong. Winning $50 million is great in anyone’s book this still kinda sucks. The government can’t possibly let anyone walk away with that much money so they take a HUGE bite knowing that you really can’t complain.

I’d take it as a lump sum. Even though your net payment (after taxes) will be less, there’s a great deal more you can do with a large sum today.

For example, if your final net sum is $1,500,000, that can easily be invested conservatively for an annual return of 5%, which is $75,000 per year. Then for the rest of your life, you would have an upper-middle-level income without ever touching the principal again. That principal could be used as collateral for loans, but as long as you keep up the payments from your interest income, it should never be touched.

Then when you die (depending on how you set up your estate), your family would continue to get a good income.

Lesson to learn: don’t borrow too much on the principal, or if you take the time payments on the incoming checks.

One of the first $1,000,000 winners of the Maryland lottery did this. He got $50,000 a year for 20 years. (The Washington Post did a follow-up on the first winners of the MD lottery near the end of their 20 years.) This guy had borrowed so much against his jackpot that near the end he had to take a job cleaning reststop bathrooms in Florida because his checks were immediately zeroed out by liens against them.