Buzz
The chances of winning the Powerball are slimmer than being struck by lightning during a frog-filled thunderstorm, but the excitement of playing with billions at stake is undeniable. If you happen to win (which, let's be honest, you probably won’t), here are some important steps to secure and maximize your newfound fortune.
Decide: Lump Sum or Annuity?
Ah, the classic dilemma every big lottery winner faces: Should you take the lump sum or opt for the annuity payments?
With the annuity, your payout is spread over time, and you’ll end up with more money. If you win the Powerball jackpot, you can choose 30 annual payments that average around $37 million each, after Federal taxes. That totals more than a billion dollars over the years. (The exact amount varies depending on your state due to state taxes.)
The lump sum gives you all your money upfront, but after Federal taxes, it’s about $651 million. Not bad, but it’s nowhere near a billion dollars. Here’s the catch: while the annuity adds up to more over time, the lump sum could still be the better option if you invest it, thanks to the power of compound interest. For example, if you invest $651 million in the stock market, which earns an average of 6-7% per year (after inflation), you’d have $871 million after five years. In 30 years—the duration of the annuity—you’d have $3.74 billion. That makes up for the difference lost by taking the lump sum.
However, it’s not as simple as it sounds. For one, you’ll need to pay taxes on the income you earn from your investments, and the annuity offers a tax advantage. Tax lawyer David Hryck explains:
If you opt for the lump sum, you'll pay taxes twice: once on the prize itself and again on any income from your investments. With the annuity, you pay taxes only on each installment, and you won’t be taxed on the money invested while the government essentially holds your winnings for you. Over time, this tax advantage can add up as your money grows without the burden of additional tax obligations.
With the annuity option, Powerball essentially invests the money for you, and according to Hryck, you earn a pre-tax return of about 2.8%. It’s not a huge return, and you could likely do better investing on your own, but keep in mind: that money grows tax-free. As The New York Times notes, “you’ll never beat the effective tax rate of zero on the investment income earned inside the Powerball annuity.”
Of course, you could also invest your annual annuity payments in the broader market, but that would mean paying taxes on those earnings too. As we’ve mentioned, it’s a bit more complex than it sounds.
These scenarios assume you’ll reinvest all your winnings, which isn’t entirely realistic (that private island isn’t going to buy itself). They also presume you have decades to invest and can weather market downturns. With so many variables at play, the final result depends on how long you can invest, what kind of returns you can expect, and where you live.
A multimillionaire shouldn’t need to do this much math.
Fortunately, Business Insider ran some calculations with a lottery a few years back, and here’s what they came up with:
If you can achieve a return rate between 3% and 4%, the lump sum is still the better option... However, it only makes sense to take the lump sum if you believe you can get a reasonable return on your investment.
Even a basic, low-maintenance investment portfolio typically averages around 6-7%, which favors the lump sum. Ultimately, it boils down to weighing the investment potential of the lump sum against the tax benefits of the annuity. Most experts believe the tax savings with the annuity outweigh the lump sum’s potential return. You may also prefer the annuity if managing large sums of money is challenging for you.
Understand the Rules, Don’t Let the System Trip You Up
Before you rush to claim your prize, take a moment to absorb the magnitude of your win. You’re a multimillionaire now, I know! It’s time for celebrations, but remember: sitcoms have taught us that acting on impulse when you win the lottery *always* ends badly.
Take your time to familiarize yourself with the rules and create a solid plan. Don’t stress about missing the claim deadline—most states allow up to 180 days. Just make sure to mark your calendar, because you’ll regret it if you let that deadline slip away!
Make a copy of your ticket and store the original in a secure location (like a safe). Once your win becomes known, expect a flood of requests from friends, family, and creditors. Forbes suggests the following strategy to handle this:
...check your state's rules to see if you can stay anonymous. Laws regarding winner publicity differ by state. In New York, for example, the names of winners are made public. However, in some states, you can maintain your anonymity by setting up a trust or limited liability company to claim your winnings, according to Beth C. Gamel, a CPA with Pillar Financial Advisors in Waltham, MA. A client of Gamel’s who won a past lottery used this strategy, with a lawyer claiming the prize for the trust. In South Carolina, where the September 18 winner purchased their ticket, anonymity is also possible.
If you’re married, your spouse is entitled to a portion of the winnings. As Legal Zoom explains, earnings from both spouses are generally considered marital income, meaning that anything bought with those earnings—including a lottery ticket—becomes marital property. If you win while going through a divorce, your ex may also have a claim to some of the prize, depending on the timing of the divorce and the laws in your state.
Perhaps you won the Powerball as part of an office pool. In this case, things can get complicated. You should’ve considered this before inviting Noel from accounting to join you, but now you’re in it. In most states, only one person can claim the prize per ticket. So, you’ll need to create a single entity to represent all winners. AmericanBar.org provides an explanation on how this works:
In situations with multiple beneficiaries, it’s best to create an entity because if only one person claims the prize, distributing shares to the others may be considered a taxable gift. Additionally, only that individual will receive the W-2G, reporting the prize as fully taxable to them. The other pool members might not be comfortable with one person claiming the prize on behalf of the group... In such cases, a formal group arrangement should be used and documented properly.
A skilled lawyer will guide you through these complexities, but it's beneficial to be prepared. Once you claim your ticket, you’ll have 60 additional days to determine how you’ll choose to receive your payout.
Determine the Taxes You’ll Actually Lose
Congratulations—you've entered the top one percent! This means you’ll be facing hefty tax bills, but unlike others, you won’t have the luxury of using tax loopholes to shield your newfound millions. You’ll need to pay what you owe.
The Powerball website has already done the math for you, showing how much you'll pay in both Federal and state taxes, depending on your location, and whether you opt for the lump sum or the annuity payout.
If you decide to quit your job, you’ll also be responsible for making estimated quarterly tax payments. A competent CPA will help you navigate this to avoid penalties. It’s fairly simple: without a full-time job, there’s no employer to withhold taxes on your behalf. So, you’ll need to make these payments yourself every few months, using IRS Form 1040 ES if you have income during the year. You can even pay these taxes online.
Remember: you're now in the highest tax bracket possible. For 2016, that means your federal income tax rate is 39.6%. With the lump sum, you'll pay all your taxes at once, so this rate won’t fluctuate. But if you choose the annuity, your rate could change over time. One tax expert explained it to Business Insider this way:
As we know, tax rates are constantly evolving. If you opt for the lump sum, you’ll face a 39.6% rate. However, if you choose the annuity, the rates will likely vary over the next 30 years. So, if you believe the top tax rate will drop in the future — or if the Flat Tax movement gains traction — the annuity might be the better choice.
Conversely, if you believe tax rates will continue to rise, taking the lump sum might be the better option.
Hire a team of trusted advisors who won’t take advantage of your newfound wealth.
At a minimum, you'll need an attorney, a Certified Financial Planner, and a tax preparer to guide you through the process.
An estate attorney will guide you through the process of setting up a Will and Trust, along with other complex legal paperwork. Here’s what estate lawyer Barry Nelson says you’ll need:
When preparing a Will and Trust, the lottery winner must address tricky non-tax-related matters. For instance, what age should the winner's children be to inherit such significant sums of money in the event of their death? Many of my clients prefer to delay large distributions to younger heirs until they’ve completed college and gained work experience, as this helps them develop a solid work ethic.
To find a trustworthy lawyer, ask a friend or family member for recommendations, or use the American Bar Association website to run a search. You could even connect with previous lottery winners, suggests Richard Morrison, who won $165 million in 2009.
When you meet with your lawyer or interview them over the phone, you should feel at ease, and they should explain things clearly. Also, be wary of this major red flag, as lawyer John M. Phillips warns on his website:
Do NOT agree to allow them to take a percentage of your winnings or anything unreasonable like that. If they suggest it, run the other way. Instead, find someone you trust and work out a fair retainer or hourly fee to help you make wise decisions and protect you from people trying to take advantage of your fortune.
When searching for a financial planner, ensure they are a Certified Financial Planner who has taken a fiduciary oath, legally obligating them to act in your best interest. Ideally, you should choose a fee-only financial advisor. This CFP should also assist you with taxes or refer you to someone who specializes in that area.
Protect Your Massive Nest Egg
A competent lawyer will safeguard your wealth by recommending a series of legal strategies and insurance products to shield you from potential risks like lawsuits, creditors, and divorce.
Forbes provides a detailed explanation of how this asset protection plan works.
The most effective defense involves creating multiple barriers that make it hard, if not impossible, for creditors to access your assets. These asset protection tactics, as they’re known, can include everything from leveraging state-law exemptions to establishing several layers of protection with trusts, family limited partnerships, or limited liability companies. A combination of these strategies might be used to safeguard your wealth.
For instance, Morrison shared with Time that his lawyers even recommended kidnap and ransom insurance to ensure his family's safety. While he declined the idea, he did hire security to protect his home and children. Additionally, he suggested claiming your prize at a lottery office that’s far from your hometown.
It’s also wise to settle any old debts and adopt some solid financial habits. Yes, you’ve got wealth now, but if it could happen to Wayne Newton, it can happen to you. Plus, any debt means you're paying interest. You’ll want to clear that off quickly so the interest on your debts doesn’t eat into the returns you get from your investments.
Generally speaking, though, you should be in a good position. With careful planning and a basic understanding of how everything works, you’ll likely be just fine. That is, of course, if you actually win.
Illustration by: Sam Woolley.
