Friday, March 30, 2012

Mega Millions: should you take the lump sum or the annuity?

If you're thinking of playing Mega Millions for the massive jackpot this weekend (don't bother, by the way, I've already got this thing locked up), there are some important things you should think about first. Yes, "what should I name my boat?" is a very important question, but before you get there you should probably figure out whether to take the lump sum or the annuity. I'm glad you asked. Here are my tips. If you're lazy or hate math, here's the Cliff Notes: take the lump sum.

According to the Mega Millions website, the currently-advertised jackpot of $540 million will result in a lump-sum payment of $389 million. That's cash in hand, today. Or, you can spread that $540 million out over 26 years, pulling in about $20.77 million per year from now until 2037. In essence, by taking the annuity, you're lending your money to the lottery administrators for 25 years.

So what kind of interest rate are you getting for being such a generous lender? Without boring you too much with the math, when I compared the lump sum to the annuity, it came out to an implied interest rate of about 2.84%. With U.S. Treasuries for a similar term (we'll look at the 30-year bond) currently yielding around 3.25%, this seems like a pretty bad deal for the lottery winner (though a very good deal for the lottery administrators).

The other thing to take into consideration is taxes. By any historical standard, tax rates (especially on large amounts of income) are at staggeringly low levels. With government deficits and debt reaching nightmarish proportions, it's pretty much a given that this rate will rise (possibly significantly) at some point over the next 25 years. Therefore, it's to your benefit to generate all of the income (and pay all of the taxes) today, rather than waiting and paying some of those taxes in the future when rates are likely to be higher.

When I ran through the numbers, I found that if tax rates were to remain at 35% for the first 10 years of your annuity payments, and then rise relatively modestly to 45% for the remainder of the 25 years, the implied interest rate on your generous lending would drop to about 2.02%, an incredibly paltry return. If those tax rates increased to 55% in Year 10, your implied interest rate would drop all the way down to 1.08%.

When you consider interest and taxes, it becomes clear that it's not really in anyone's best interest to lend out long-term money right now (hey, maybe that's why nobody can get a mortgage these days...), least of all to the government, who might want to take a bigger bite in future years. So take the lump sum, and try your best not to blow all your many millions in one place. I will try my best to take my own advice when I win this thing later tonight.

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