The Big Mistake Most Lottery Winners Make




 

Every year, millions of people play the lottery, handing over their hard-earned money to try to get rich in the quickest way possible. With multistate lotteries like Powerball and Mega Millions offering prizes that are often in the hundreds of millions and have sometimes topped the billion-dollar mark, nearly all lottery winners find their way into the spotlight.

Yet as life-changing as winning the lottery can be, it also requires winners to make a smart initial decision: whether to take a reduced lump sum upfront or receive the full amount of the jackpot over a long period of time through yearly annuity payments. Most lottery winners choose the lump sum, and although that might well be what the math would tell you to do in most cases, passing up the annuity is often a huge mistake that can prove to be devastating.

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Why most people say you should take the lump sum

To understand why most financial advisors argue you should take the lump sum, you first have to know what the two options really entail. Rules differ across various lottery programs, but for the Powerball and Mega Millions lotteries, here's how it works:

Knowing how the numbers are calculated makes it easier to figure out why taking the lump sum is typically the recommended choice. The lump sum amount is based on investing in Treasury bonds, which have historically had a relatively low rate of return compared with stocks. If you take that amount and then put it into higher-returning investments, then you should be able to produce better returns and end up with more money. Moreover, taking the lump sum means not having to worry about whether the lottery program will make good on its annuity payment obligations in the future -- a minor concern but still one that bothers winners.

There are some countervailing financial reasons to take the annuity, however. When you take the lump sum, the entire amount is taxed immediately. That makes nearly all of a typical Powerball or Mega Millions prize subject to tax at the highest possible rate. By contrast, if you break your winnings into smaller pieces, only the amount you receive each year gets treated as taxable income. That gives you more access to lower tax brackets over the long run. It also leaves you exposed to changes in tax rates, which can help you if they fall in the future or hurt you if they go up.

The best reason to break up your payments

However, there are more practical reasons to avoid the lump sum, having to do with human nature. Many lottery winners have a lot of difficulty hanging onto their newfound wealth for a variety of reasons:

In that light, taking payments over 30 years has huge advantages. It essentially forces you into a financial plan, giving you access to just a portion of your total winnings each year. It gives you time to get used to the idea of having significant wealth, and you can make big mistakes and learn from them without blowing your entire winnings. Even if you go through the entire annual check, you'll just have to wait a few months until the next one comes.

It's not always about maximizing wealth

Lottery winners quickly learn that despite the temptation of having full access to their entire winnings, the more successful way to handle their good fortune is to recognize that their windfall has to last a long time. Even if it means getting less money, the odds of a happy outcome are a lot better by electing to take payments over time rather than all upfront.

The Motley Fool has a disclosure policy.

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