GUEST POST from Don: Winning The Lottery

WINNING THE LOTTERY

There has been an increased interest in lotteries recently.  Two things in life have very high probabilities: death and taxes.  Of the two, taxes have the higher probability (because you can be taxed more than once on the same money).  Honestly, after Federal taxes, the average winner keeps only 1/3rd the promised payout … and they are happy about it??  Then they have to deal with the most greedy people on earth; their relatives.  Most lottery winners follow poor advice: Their own.  

The last Mega Millions winner was sold April 14, 2023.  The Grand Prize was $483 million.  However, the winner took the lump sum of $257 million.  We will use this as the example throughout this post.

1. Lump sum or annuity?

This is the most important question you have.  How good is YOUR investment track record?  If you have done well (your money has grown by an annual rate greater than 8%), maybe it would serve you well to take the lump sum.  

You don’t know how well you’ve done?  You have less than $20,000 invested?  You do not have ANY money invested?  Do the annuity.

2. Federal Taxes.

OK.  You do know that you will pay federal tax, right??  Before you choose “lump” or “annuity” it would be wise to know all the taxes due.

If you take the lump sum you will pay tax on ALL of your winnings.  The IRS Form 1040 allows you to deduct thousands on which there is no tax due, but if you are employed you probably already exceeded that number.  

The lump sum is generally less than 60% of the annuity.  However, if you take the annuity you get 2 benefits.  First, you will get about 47% more money over 30 years (almost double the lump sum).  Second, you can use the tax code to your advantage (since you are no longer employed) and will be able to deduct your personal exemptions and pay lower tax rates on the first $half-million EVERY YEAR for 29 years.  Let’s assume you are married and the standard deduction is $28,000 (this year it is slightly less).  That is $28,000 of tax free winnings every year for 29 years (for a total of $812,000 of tax-free money).  That is a true gift which puts at least $300,000 back in your pocket over the next 29 years.  But that’s not all.  

The next $11,000 is taxed at only 10% each year for 29 years (not the maximum of 37%).  If you took a lump sum, you receive that gift ONLY the year you won.  However, with the annuity you get that discounted tax rate every year.  You are on the hook for $1,100 in federal tax for 29 years.  But on the lump sum you will pay 37% tax on that same money.  Thus, you will save 26%.  That’s another $2,860 in your back pocket 29 years in a row.  ($83,000 total).  Just these two items put $805,000 back in your pocket.  Put that another way…Uncle Sam will reward you when you take the annuity; you could buy a new car or truck every 3-4 years with the savings.  

3. State and Local Taxes.

The city and state in which you reside matter.
Here are the 5 states with the highest taxes on lottery winnings:
1. New York – 8.82%
2. Maryland – 8.75%
3. New Jersey – 8%
4. Oregon – 8%
5. Wisconsin – 7.65%

If you live in one of these states (or several others) you have incentive to take the annuity and MOVE to a state with 0% tax on lottery winnings:  Alabama, Alaska, California, Delaware, Florida, Mississippi, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Utah, Washington, and Wyoming.  

So, if you win in New York, and take the lump sum, they will grab $22.66 million out of your winnings.  But if you take the annuity, and then move to Tennessee before January 1, NY will only siphon off $1.42 million.  I think you could find a house in Tennessee for the $21 million you just saved in taxes, don’t you?

4. Grand Total.
Person A took the lump sum.  After federal taxes kept $161.9 million.
Person B took the annuity.  After federal taxes kept $10.2 million per year for 30 years.  
In the end Person B kept $305 million.  
Summary:  Person B caught up to Person A’s net prize in just 16 years.  And kept getting money for an additional 14 years.

5. Option: Investments.
Let’s say you were smart enough to invest $2 million at 9% when you got your lump sum.  How much would you have 30 years later?  Assuming you kept enough of your prize money to pay the taxes on the interest, you would have a growth of $24.5 million.  Does this make up for the losses?  Nope.  With an annuity you get $143 million more.  With the investment model you lose $118.5 million plus tax on the interest growth.

So, how much would Person A have to invest (plus pay taxes on the growth of) to equal what Person B got?  $12 million?  The first year Person A would have a growth of over $1 million.  That would have a federal tax of $350,311.  If Person A did not reserve any money for tax on interest, he would have to take the money out of the investment to pay the taxes.  That leaves him only $729,689, or a growth rate of only 6%.  You can live on $729,689 annually.  Yet it still does not equal the amount Person B will receive.

In fact, Person A would have to invest $16 million (10% of their net take) at 9% return (paying Federal taxes out of their interest earnings) to achieve what Person B will get without the bother of managing investments.  That’s just to break even.  Who will do that?

6. Smartest Choice.

If you are very, very smart (rocket surgeon smart), and already live in a zero tax state, … take the lump sum and invest $161 million.  That still leaves you nearly $900k after taxes for year 1.  Every year FOREVER after you would receive about $14.4 million in interest.  This easily beats Person B (if B invests nothing).

If you are this smart, take the lump sum.  If you are not this smart, take the annuity.

I wonder:  What’s the chance of a lottery winner being incredibly smart?  

Copyright 2023 Donald Whelpley

[PLEASE NOTE that Don is always open to discussing the thoughts and opinions he shares here and welcomes comments as shared in the comment section. He doesn’t use other social media platforms, as I do, and won’t see whatever you’d like to share with him elsewhere. ~ Sherry]

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