Winning the lottery is a dream come true, but with it comes a big decision: do you take your winnings in one lump sum or spread them out over 30 years? Important factors to consider include your spending habits, life expectancy, family, and outlook on taxes and inflation.

Lump Sum or Annuity?

Before we get into taxes, let's look at lottery lump sum and annuity payouts. Lump sum payouts are significantly less than annuities. Do not be confused – this has nothing to do with taxes. Lump sum payouts on most lotteries are typically half the advertised jackpot (40-60% depending on state regulations). The only way to get the entire jackpot is to choose the annuity option.

For example, if you win $1,000,000 in the lottery and you choose the lump sum option, you will receive $500,000. To get the full $1,000,000 you have to opt for the annuity.

Gimme Money

Your friends and family may have trouble understanding that. Here's what that looks like:

"My brother won a million dollars in the lottery!"

"Sweet! You think maybe he could throw some our way? We could pay off our credit cards and student loans! $100,000 would only be like, what, 10 percent? Let me see your phone, mine's dead."

"They don't give you the whole million dollars, Jimmy."

"I know, you have to pay taxes. Just like we do."

"You mean I do."

"Hey, I'm looking, I gotta couple leads. Wow, your brother is LOADED! He's probably rolling around in gold coins right now. I'm calling him. Hey bro, it's Jimmy. I heard you won the lottery! Gimme money, gimme money, gimme money!"

Life Expectancy

Average life expectancy in the U.S. is about 78 years. Based on our family history and lifestyle, we have a pretty good idea where we stand in terms of surpassing the average or falling short. It's simply a matter of subtracting 30 years from your anticipated life expectancy and comparing it to your age.

Jane smokes four packs of cigarettes a day, eats a steady diet of donuts and fried chicken, and has never exercised a day in her life. She is 57 years old and no one in her family has ever seen their 70^th birthday. Jane is a good candidate for the lump sum payout.

Rick is a 34-year-old vegetarian who regularly competes in triathlons. Rick is clearly free to choose between the lump sum payout and the 30-year annuity.

Spending Habits

As pointed out in How Your Personality Affects Your Finances, your spending habits have a significant impact on the success or failure of your personal finances. If you struggle with credit card debt and overspending, a lump sum payout could make matters worse. You might join the thousands of others who went broke within five years of winning the lottery. You can protect yourself from yourself by choosing the annuity.

If, on the other hand, you are a saver and a good investor, you might consider the lump sum payout. 

Taxes and Inflation

Because taxes and inflation deal with unknowns and the time value of money, this part is less clear than life expectancy and spending habits. If you find this confusing, base your decision on life expectancy and spending habits.

When you take the lump sum payout, it puts you in the highest tax bracket, currently 37 percent. If you live in a state with state income taxes, you'll fall into their highest bracket, too. That means a larger portion of your lottery winnings will go to taxes compared to if you had taken the 30-year annuity. So you should take the annuity, right?

Not so fast. Many believe that runaway government spending will lead to higher taxes. In years to come, today's tax rates may seem low by comparison. If that is the case, taking the lump sum payout would shield you from future tax increases which could result in less overall taxes. So you should take the lump sum, right? Not necessarily.

Besides taxes and entitled relatives, the biggest threat to your money is inflation. Inflation causes the price of everything to go up which reduces your buying power. Lottery winners who take the lump sum option can combat the effects of inflation by making wise investments. Using lump sum lottery winnings to buy securities with returns that exceed inflation, you could potentially put yourself ahead of the game. Conversely, opting for an annuity in a period of high inflation will have you waiting for payments that are worth less and less each year.

What Should You Do?

Who knew winning the lottery could be so hard? It's a lot to consider. Let's look at an analogy. Imagine you win $1,000,000 in the lottery, and the lump sum and annuity options are in a foot race to the finish line. They square off at the starting line and the gun goes off. Right out of the gate, the annuity teleports halfway to the finish line.

Wait, what? How did that happen? As pointed out earlier, annuities pay twice as much as lump sum payouts. This represents a huge advantage for annuities. But the race isn't over yet. Here comes another blow to the lump sum: friends and family. Everyone hears you won the lottery and they want their fair share. With an annuity, you don't have that problem. One million dollars spread out over 30 years comes to $33,333 per year, which is less than the median income. No one will come clamoring for that.

Finally, there are taxes. Taking the lump sum means taking a huge hit in taxes. In our $1,000,000 example, the lump sum has already dropped to $500,000, then 37% in taxes comes to $185,000 leaving you with $315,000. 

Meanwhile the $33,333 per year is in the 12% tax bracket which works out to $4,000 each year in taxes. That leaves you with $29,333 after taxes which over 30 years adds up to $879,990. 

So there you have it. The lump sum stumbles over the finish line with a measly $315,000 while the annuity finishes strong at $879,990. That is almost three times as much.

This is by no means a comprehensive analysis. Your earned income would be added to the $33,333 annuity payments which would likely place you in a higher tax bracket. Also there are tax increases, the time value of money, and state taxes to consider. Still, this quick analysis paints a pretty clear picture. Unless you don't think you will live another 30 years, the annuity is the better deal. Even if you are a good investor, the lump sum has too many headwinds to come out ahead over the annuity.

Photo credit: Pixabay The Eggstack Blog will never post an article influenced by an outside company or advertiser. Our mission is to help you overcome uncertainty about retirement planning and inspire confidence in your financial future.