If you and /or a spouse / family member / friend ... won the lottery ... inherited money ... are analyzing retirement plan or pension distribution choices ...
As a Financial Advisor, I'm not a qualified Family or Marriage Counselor ... but unquestionably that field of study and skill set would be very useful in my field, too. If you are part of a couple, ration-based ideas might appeal to one of you more ... and the other of you might be swayed by more emotion-based ideas. Read on for some of both.
Before reading this article and working on this post, I almost certainly would have taken the Lump Sum. Now ... if I'm honest with myself ... it's an open question ... but also please see below...
“First, some background: You might not realize this, but the top prize in the $1.5 billion Powerball (in early 2016) is not actually $1.5 billion. (Nor is it $999 million, as many of the three-digit-readout lottery signs around the country say it is.) If you take the prize as a one-time cash payment, you will get a mere $930 million, before taxes.”
Source: NY Times
Now some key bullets . . .
- Annuity Certain- Definition
"A financial instrument that provides a stream of payments, for a predetermined number of years. An annuity certain will continue a stream of payments remitted to the annuitant's beneficiary or estate, if the annuitant dies before the payment term ends. The payments are made on a regular schedule, such as monthly, quarterly, semiannually or annually."
Source: Investopedia - Tax Advantage
". . . there are big tax advantages to the annuity. The main one is that taking the annuity is basically like letting the government hold onto part of your prize for a while and invest it for you — and the government does not pay tax on investment income. Of course, once you get the annuity checks, you’ll have to pay income tax on them. But if you take the lump-sum cash prize, you’ll pay tax twice.”
Source: NY Times
(Bruce's Note: When you receive the lump sum you pay taxes the first time. If you invest any of the money in any taxable investments, you pay tax a second time.) - Tax Disadvantage
". . .there is a potential tax disadvantage with the annuity. If you die before it’s finished paying out, you can leave the future payments to your heirs, but the I.R.S. will want to collect estate tax right away on those payments’ future value. If you die shortly after getting the prize, you won’t have nearly enough cash on hand to satisfy the taxes due.":
Source: NY Times - Unforced Errors
A. Also known as ... protecting yourself from your own poor decisions. For the non-tennis players among us, please forgive the sports analogy language. I looked it up and the term "unforced error" can be found applying to other sports ... but overwhelmingly to tennis
B. For the purpose of this note, I'll call an "unforced error" a decision you made yourself without consulting any ... spouse ... expert ... financial advisor ... for decision-making help.
C. I will call a "forced error" a decision you made partially because your spouse / sibling / parent said something emotionally influential ... e.g. "Honey, if you don't do X, you're sleeping on the couch!"
D. Behavioral Finance: This is not the correct use of the term, but it is an area of increasing interest to me People making decisions not based on completely rational factors. - Who Knows a Good Family Therapist? (!)
If you take the annuity, the size of your error or the mistake that you and / or your Loved Ones can make is limited by your existing financial resources. The Lump Sum makes those dramatically larger so increases the size of a potential error ... forced or unforced ... exponentially.
"What Is an Immediate Payment Annuity?'
"An immediate payment annuity is an annuity contract that is purchased with a single lump-sum payment and in exchange, pays a guaranteed income that starts almost immediately. An immediate payment annuity is especially suitable for retirees who are concerned about outliving their savings. However, one disadvantage is that an immediate payment annuity is irreversible once it has been purchased. This may pose a problem should the annuitant need a large sum to deal with an emergency."
Source: Investopedia
The Bottom Line
The "Powerball" example happens a lot more in real life than you might think ... perhaps most often when at or near retirement ... dealing with a 401-k ... TSP ... or perhaps a pension buyout or a 401(k) possible rollover ...
In many situations, you might be faced with an "all or nothing decision" ... "Take the Annuity" ... or "Take the Lump Sum."
In the Powerball example, you actually have potential flexibility ... and it doesn't have to be 50-50. But you could split the difference down the middle. You could take the lump sum. Then you could immediately purchase an Immediate Payment Annuity on the lives of you and your spouse if married with half of the (net after tax) Lump Sum. You'd have Guaranteed Joint Lifetime Income that essentially gives you an opportunity to make a new mistake every time a new payment comes in. The payments would never stop as long as either one of you were alive. And you could use the Lump Sum for other purposes.