The Lottery and Annuity Calculations

Cecil's Columns/Staff Reports
41

It’s 35%, considering JUST the federal taxes (yes, state taxes push that up quite a bit, and if I were you I’d move to a cheaper state before getting your pay off). Meaning you’d take home a lump sum of $325,000 (assuming you don’t pump part of that into school expenses, mortgage interest, gifts to charity, medical expenses up to a point, expenses for starting a home business, IRAs, 401ks, 503cs, and other little tax shelters which would give you more loot down the road while increasing your “worth”). The tax bracket for a married person making less than $100,000 is more like 25%, again considering all that other crap is ignored.

The difference is $325,000 now, versus $750,000 over the next 20 years. A little over 230% better.

Of course, there are reasons to take the lump sum. A good one would be investing in a new sole proprietership. You could use that full $500,000 to purchase a TON of great equipment and basically take a loss the first year…and pay little tax (basically, only on the amount you DON’T invest in the business, AFAIK). Then, you use your equipment to start making money the following year. Make sure you get a good accountant! There are some forms of business that do this consistantly and as such pay hardly any tax – mostly R&D firms.

Another reason to take the lump sum would be if you planned on leaving the country without paying tax on it. There are some fine nations with low costs of living and no extradition treaties with the US. You could live like a king in such a nation. You COULD be a king in such a nation!

And finally, if you’re over 60 years old, take the lump sum. Most lotteries won’t give your kids the balance.

42

You could avoid some tax, but not all of it. Lotteries withhold taxes on any prize over a certain amount ($5000?). Withholding is at 25% Federal and whatever the state tax (and perhaps local tax) is in the place that you bought the ticket. Not saying that you can’t live the good life somewhere else (I can think of a dozen places off the top of my head where you could live like a king for $10k per year), but you won’t be able to avoid some pretty hefty taxes.

43

Quoting from the website link provided by 5cents:

This is what I thought, that when you have a choice of payment forms, “constructive receipt” says that you’re taxed as if you were given lump sum cash. This applies to prize winnings on game shows, too – if you win a car that’s worth $30,000, you will be taxed on the value of the car as if you were given cash. And that’s why I didn’t bother to include tax treatment as a consideration for the annuity/lump sum choice – that tax would be the same in absolute terms, taxed as if you had chosen the lump sum, regardless of when you actually received the cash.

However, I was unaware of the further dodge:

Thus, if you select in advance, and thus avoid constructive receipt, the tax angle does come into play. I will amend the Staff Report to include a brief bit on this. Thanks, 5cents, for finding the info.

44

You missed the most important part, which is in the next paragraph:

What this means is that, essentially, any prize awarded since 10/21/98, the winner has 60 days to make a choice as to how they want the prize awarded, and if they make the choice within that time, they avoid the “constructive receipt” doctorine. There’s a whole bunch more in this article; the reading is a bit dry, the info (especially on tax rates) is out of date, but it does seem pretty comprehensive.

So to summarize, there are two tax advantages to taking the payments. First, the tax will be lower, because you are paying tax on 1/26 of the prize every year. This is a big deal for “small” jackpots (say, under 25 million), and becomes a bigger deal as the jackpot becomes smaller. Second, the tax is deferred. This is a big deal for any jackpot.

There are a few disadvantages to taking payments. First, if you die before the payments are done, your estate (and therefore your heirs) will be liable for all the taxes, right now. Not a big deal if the jackpot is relatively small (assuming your estate has some value to it), but it can be a really big deal if we’re talking about a $200 million jackpot. Imagine if you win such a jackpot, and die the day after you choose to take the payments. Your estate will be liable for about $40 million in taxes, and you’ll only have about $5 million (the first payment of $8 million minus taxes) in hand. Getting a loan to cover this shouldn’t be a problem (you’ve got a guaranteed $8 million tax-free income for the next 25 years), but you can’t expect to just walk into your neighborhood branch and arrange it.

The other disadvantage that people have mentioned, that you want the lump sum right now because you want to start a business, doesn’t hold water because with the kind of guaranteed income a lottery jackpot brings you should have no problem getting a loan (or other financing) to start up a business. You get a triple tax advantage with this setup: the two tax advatanges of taking the payments, plus interest on business loans are tax free. Unless interest rates suddenly jump to 25%, it’s hard to see where taking the lump sum makes sense in this case.

All in all, it looks like all the advantages (except for lump-sum taxes in case of death) fit squarely into the “take the payments” side of things.

45

Congrats to Scylla for what I think is the best and most complete answer we’ve seen so far. Pay attention to Scylla.

46

OK, here is what i would do with a smaller win (let’s say $1million) if the interest on the annuity is higher than the current interest on a mortgage (about 5.75% for conforming loans right now, higher for Jumbo)

Let’s assume I do not have a house.

(1) Take the annuity
(2) Get a mortgage with a monthly/annual payment equal to your annuity. The mortgage amount will be HIGHER than $1 million, since the interest on the mortgage is lower (see assumption). You can probably get a really nice rate, since the credit risk is not yours, it’s the one of the lottery that counts. Lawyers can figure out the rest, maybe even put the whole thing in a trust, lottery win an house and all.
(3) buy a house worth exactly the mortgage you can get (well, maybe plus 10% equity, they are sometimes picky, but given the really low risk of your income, I bet you could finance 100% of a house)

That way, you get a house that is worth more than the lump sum you would receive. No taxes on the lump sum. The interest on the mortgage is tax deductable, so some of the taxes for annuity payments cancel out. Not all, since there is a principal payment involved, so you will have to pay some income taxes over time. That is the only tax you have to pay, and it is spread out over the time of the pay-out.

If you already own a nice house, do the same thing with refinancing

Comments?

47

Sorry for the typos, …

one more thing: the whole thing is also inflation-protected, if you assume your house value goes up with inflation. Of course the value could also go down, since you are taking the real-estate risk.

And you have an issue if you sell before the annuity runs out, I guess.

But still, you fundamentally get more $$ than the lump sum.

48

I like it, except that your money is tied up in a house. Note that if you find a good business to invest in, you could do the same thing…

49

I like it, except that your money is tied up in a house. Note that if you find a good business or apartment block to invest in, you could do the same thing and get cashflow.

50

Rental property is actually a really good idea - but the interest rates charged to finance it are typically higher. But since you have the annuity as guarantee, you are fine.

Of course you have the risk of the rental market, but on the other hand, you can finance higher something more expensive than the lump sum.

51

5cents comments: << Second, the tax is deferred. This is a big deal for any jackpot. >>

Caution, here. Tax deferral is advantageous IF the tax rates stay the same or are reduced in future. If tax rates go up in the future, then tax deferral may have been a bad idea.

All the comments on what to do with the winnings are interesting but not relevant to the choices. As we said in the Staff Report, it depends on what rates of return you think you can generate through whatever investment (bonds, property, whatever) you’ve got available… and how that compares to the rate underlying the lottery annuity.

52

Emphasis on “may”. Even if tax rates go up, deferral can still be a good idea. What matters is how much and when. Also, tax brackets, exemptions, credits and deductions generally float up over time.

I disagree. If a large percentage of the money is spent on something deductable (like a business loan or mortgage), you really don’t care what the tax rates are because you don’t have much taxable income. This makes payments much more attractive because you have essentially eliminated tax rates as a risk.

53

A fool and his money are easily parted. Take me for example. :slight_smile: Here is a record of my lottery expenditures since Jan 1, 1996 (from my Quicken data file):

TOTAL Casino Losses…-375.00
TOTAL Casino Wins… 254.00
TOTAL CA Fantasy 5…-9,279.00
TOTAL CA Scratchers… -139.00
TOTAL CA Super Lotto…-5,213.00
TOTAL Non-CA…-15.00
TOTAL Lottery Tickets…-14,646.00

TOTAL Lottery Wins…3,577.00
TOTAL Losses…-11,200.00

When I ran this report a couple of years ago, I cut back a lot on lottery playing when I saw how badly I was doing. One would think I would know better with a college degree in computer science to back me up :eek:

As for cash or annuity, in California the default is annuity if you don’t specifically check the cash box. Don’t know if you can change your mind later. Also, to the best of my knowledge, there is no state tax on lottery wins in CA.

Most of the state lottery’s seem to be run using machines from GTech Corp. All have the same pattern where a very few people win (sometimes) win a big jackpot. CA has had something like 2000 people win a Super Lotto jackpot out of 36 million people in the state since 1986! I think states could get a lot more people to play if they limited the top payout to say 3-5 million in one lump sum and structured the odds so that there would be many more winners in the 300-500k range. That amount of money, for most people, would be a life-changing number.

54

And the math is trivial. Most state lotteries pay out about half the money they take in in prizes. The average take is therefore about $0.50 on the dollar. However, that’s the mean, and since some lottery prizes are skewed towards one big jackpot, you’d assume the median is lower, say about $0.25 to $0.35 on the dollar. Kind of matches your experience, right?

Casinos in Vegas pay out more than 90% of the money they take in in prizes. So again the math is quite simple, since you are talking about an average of $0.90 for every $1 you spend. Since they don’t have too many payouts skewed to the high end, median should only be a little lower, say $0.85 on the dollar.

I’ve seen a few articles written by economists and accounts claiming that state lotteries are simply a very highly taxed form of gambling. Here’s one article that I could find quickly, written by a free-market libertarian: http://www.mises.org/fullarticle.asp?record=249&month=9. The ironic thing about state lotteries is that many of them are used to fund education. If math education was better, the lotteries would be out of business.

55

While lotteries are one of the worst “bets” you can make, in terms of the percentage of “vig”, most people don’t play a lottery as if it were “betting” in the casino sense, 5cents. They play the lottery solely for the hope of hitting a very large jackpot. They don’t expect to get any return other than the big one should they get amazingly lucky.

Of course, to help them keep that starry-eyed approach, most lotteries offer lesser prizes, usually down to some relatively trivial thing like $5 for matching 3 of 6. This helps fuel the star-filled eyes, since a person thinks, “Gee, if I’ve won $5, I’m lucky! I’ll win the whole shebang next!” It doesn’t matter if you tell them what the actual odds are; they don’t care. Of course, if they really knew (or had their noses rubbed in) how much they spend annually on all the lotteries they play (as iamme99 found out), THEN they might think twice about plunking $5 down four times a week for quick picks. Then again, if that sort of thinking dominated our society, who the heck would buy cigarettes at the prices charged these days??

I find it very interesting that there has been an interesting fallout at the casinos from the current lotto-mania. In the past, slot machines chugged along offering relatively low top prizes, such as 1000 nickles for three bars across. But the need to offer something showy in this day of Mega Million lottery prizes has forced the casinos to offer such things as progressive payouts, as well as substantially pumped up top prizes on slots. So the effective vigorish has substantially increased for any player who doesn’t hit the progressive jackpot. This makes it far less remunerative for anyone who doesn’t want to sit in front of a slot machine for hours on end like a mindless moron. Of course, if such people didn’t exist, who would watch Tigers games? :wink:

56

The odds of winning the CA Super Lotto are 1 out of approximately 41 million. But many people have a lot of problems groking numbers in the millions and this is very evident when you see people buying 20,30,40 or 50 tickets for a drawing. They don’t understand that 20/41,000,000 is just about the same as 1/41,000,000! It’s very sad since most of the people buying the large amount of tickets appear to be retired people or blue collar workers.