Conventional wisdom has it that when lottery winners elect to receive their winnings in the form of an annuity, the lottery uses the prize money – the amount that would have been paid over in a lump sum prize – to purchase an annuity. This annuity provides payments over the next 20, 26, or 30 years to the winner, the total amount of which equals the lottery’s grand prize. There is no record of any lottery prize annuity ever defaulting, but given the amount of money involved, it’s certainly legitimate to wonder about the safety of those annuities.
An annuity is a series of annual payments over either a set period of time or a lifetime. There are several ways to differentiate among them – fixed or variable, immediate or deferred, lifetime or period certain. When lottery winnings are annuitized, they are structured as period certain, fixed immediate annuities, generally acknowledged to be the safest annuities. However, while only insurance companies can sell annuities to the general public, the amounts of many lottery annuities preclude them from being purchased from insurance companies, because most such annuities are insured only for the first $250,000 to $500,000.
When a lottery is held, the winner may elect to receive a lump sum payment of all the amount of money in the prize pool, or to receive 20 or more annual payments. It’s the total of these annual payments that constitutes the grand prize that’s advertised to generate more ticket sales; the amount of money in the prize pool is significantly less. The lottery commission uses the money in the prize pool to pay out the first annual installment of the winnings, and the balance to purchase US Treasury securities maturing each year for the lifetime of the payouts. The lottery payout has been annuitized, but it is not, strictly speaking, an annuity that has been packaged and sold by an insurance company. While not individually insured, the securities underlying a lottery payout are backed by the full faith and credit of the US government, and are the safest available investment products. If anything, the annuitized payments set up by lottery commissions are even safer than the traditional annuities sold by insurance companies.
When a lottery winner elects to receive the lump sum payment, federal income tax is due on the entire amount. Lottery commissions generally withhold 25 percent of the payout for federal taxes, and winners are responsible for settling accounts when they file their income taxes the following year. Some states tax lottery winnings, while others do not. If the annuity is selected, though, income taxes are due only on the individual payments when they’re received.
Other Safety Issues
History shows that many lottery winners are too unfamiliar with dealing with the large amounts of money typical of many modern lottery jackpots. Of those who elect to receive the lump sum, many file for bankruptcy within just a few years. The annuitized payments may therefore seem like a safer option to influence more careful spending, but even those who receive annuitized payments frequently run out of money shortly after the last payment. Lottery winners are well-advised to secure solid financial and legal advice before claiming their winnings.
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