Congratulations! You've just hit the jackpot! You're due a sum of money that comes with an impressive number of zeros. Now comes the bigger question, do you want the money in installments or in one big old lump sum?
Although you may fantasize about winning the lottery, you probably aren't prepared to deal with most pressing question that comes with this type of financial fortune: to lump or not lump?
Whether you're considering lumping a retirement pension, an inheritance, or some other financial windfall, here's a quick guide to help you make the best decision for your situation:
What is a lump sum?
Although this question might seem obvious—collecting one payout for a sum that would otherwise be broken into yearly or monthly installments—you might not be processing a lump sum's actuality.
An easier way to process a lump sum payment, is to think of the money you're promised as a pie. You can either wait to receive this pie one slice at a time over a given time, or you can give a small portion of your pie to someone else, in return for receiving the rest of the pie at once. Here's the important take away: lump sums come at a cost. Many people fail to make this realization.
The big question is how much will a lump sum cost you?
So, how much will a lump sum cost you?
To figure out how much a lump sum will cost you, you will need to do some simple math.
For instance, if you are due to receive a monthly payment of $1000 dollars for 10 years, you would figure out the annuity's total value like this:
$1000 X 120 = $ 120,000
Once you have the total figure, you can compare the lump sums offered to you. Seems simple, right? Unfortunately, that's not all to consider.
So, what costs come with a lump sum?
In addition to the portion of your money you will forfeit when you opt for the lump sum, you will also incur a few other costs.
- Taxes: when you opt for a lump sum, you will be forced to pay taxes on the entire windfall immediately. Depending on where you live and what income tax bracket you find yourself, this could cost you up to 30 % of the total lump sum.
- Responsibility: another "cost" many consumers fail to consider when opting for a lump sum, is the financial responsibilities that come with it. When you have a lump sum you're responsible for managing your money. If you fail to invest or budget wisely, you might exhaust your retirement too quickly.
So, why would anyone opt for the lump sum?
Opting for an annuity versus a lump sum also has its downsides. For instance, many annuities do not offer inflation protection. Because inflation rates have steadily climbed at about 3 % a year, the $1,000 payment you received two decades ago will likely have the purchasing power of $500 twenty years later. In a way, your monthly payment loses 3 % of its value every year.
Additionally, if you feel confident managing your money or you have a clever investment opportunity, you may find an annuity lacks the investment power of a lump sum. For instance, if you invest your lump sum in a standard S & P 500 Mutual Fund, you can expect to earn 4 % on your investment annually.
Lastly, opting for a lump sum makes particular sense if you are willing to deposit the money in a 401K or Roth IRA. Both of these standard retirement plans allow you to pay taxes as you take money out of your account. Thus, the burden of paying taxes on your lump sum is defrayed over time. The catch is, you will need to wait until you are 62 to start withdrawing funds without incurring a penalty.
Deciding on a lump sum or an annuity can be a very daunting proposition. These tips can you weigh the costs benefits of the two options.