Winning the lottery or otherwise suddenly coming into a large sum of money creates a set of challenges from a financial and estate planning standpoint. While it’s a problem many of us would like to have, it is a challenge nonetheless. Just one or two improper decisions at the outset can have unwanted ramifications in the future.
I’m going to focus on the lottery, given this week’s $1.5 billion Powerball jackpot, but most of the guidelines apply to any situation where a large, sudden windfall of money is involved. Even you are not so fortunate, the suggestions below may help you better manage the wealth you have been able to build through savings and hard work.
Give Thought to Whom the Winnings Will be Distributed: Ownership has tax implications for the primary recipient and anyone the recipient wants to share the wealth with. Lottery tickets are presumed to be owned by the buyer. Depending on an individual state’s law, the buyer’s spouse may be legally considered to have joint ownership. Inheritance can be treated in the same manner, as can proceeds from the sale of a business or employee stock options. Gifts are generally taxable based on their prevailing value: A Powerball ticket gifted before the drawing has a value of $2, whereas a winning ticket is worth the amount won.
Lottery winners should consider postponing signing their ticket until consulting a lawyer. Using a trust, a limited liability corporation or other similar entity may be advantageous. (Check with the lottery commission of the state you purchased the ticket in for the specific claiming rules. If the tickets were bought for a group, work with a lawyer to avoid disputes and clarify the distribution of the winnings and associated tax liabilities.) Similarly, those with significant assets or those who foresee themselves as coming into a large sum of money may find it valuable to consult with an estate lawyer in advance.
Carefully Decide How the Money Will Be Distributed: Lottery winners have the ability to choose between a one-time payout and an annuity certain. The annuity is a total of 30 payments: one immediately and the remainder paid each year thereafter. It is an annuity certain because payments will continue to be made to the estate of the winner should the person pass before all the payments have made. There are advantages to both options.
The decision as to which to choose depends on a few factors. The first is the level of returns a person can reasonably expect to achieve on the cash payout. Managed diligently, the cash payout should result in a greater ending wealth over the 30-year period (though taxes, investment fees and expenses, and withdrawals will need to be considered). The annuity option guarantees a rate of return, avoids errors in the management of wealth and is more simplistic. The less familiar a person is with portfolio management, the more the annuity option may make sense. The cash payout makes more sense for those with a strong understanding of portfolio management and the discipline to stick to a well-thought-out strategy.
A key number to consider is the discount rate. This is the expected rate of return priced into the annual payout. It is compensation for the time value of money, meaning what you are being paid for not having immediate access to your money. The New York Times says the effective rate used for the Powerball’s current jackpot is 2.843%. The higher the likelihood of realizing a 30-year annualized return in excess of this number, the more attractive the lottery’s cash payout becomes. Just realize that overconfidence in one’s financial abilities is a very common behavioral error.
Those facing a qualified one-time lump sum payout of their pension instead of a lottery jackpot need to factor longevity risk into the equation. If a longer-than-average lifespan is expected, it may make sense to transfer the risk of outliving your savings to the annuity provider.
Update (or Establish) Estate Documentation: While consulting a lawyer, use the opportunity to review your estate documentation. Wills and trusts may need to be updated. The welfare of children (or grandchildren) will need to be addressed. Be sure to review all powers of attorney and consider how your change in wealth might alter the attitudes of those trusted to see to your affairs.
Determine Where the Money Will Be Deposited: The Federal Deposit Insurance Corporation (FDIC) only insures accounts up to $250,000. The Securities Investor Protection Corporation (SIPC) insures cash balances up to $250,000 and investment accounts up to a total of $500,000. Plus, the second you deposit funds totaling $1 million or more, the financial institution’s wealth management department will want to talk to you. (You don’t have any obligation to speak to them.) Given this, it may make sense to spread the money across a few accounts at different institutions. Pay attention to where the cash sweep of brokerage accounts are directed; you may inadvertently have more money directed to the same financial institution than you intended. Whatever option you choose, make sure you can do a full withdrawal relatively quickly and without penalties until a long-term plan for managing the money is created.
Create a Spending Plan as Soon as Possible: Large sums of money can quickly alter a person’s sense of wealth. While it may seem daunting to spend sums equating to seven or more figures, there are various articles about lottery winners who went on to incur financial problems. Many professional athletes also encounter financial problems despite signing very large contracts.
Thus, while the temptation might be to be immediately start spoiling yourself and/or relatives, take the time to create a financial plan. This plan should include what you intend to splurge on (e.g., new house, a brand new Mercedes, a vacation, children, etc.), what charities you want to donate to (speak to them before making a large donation) and which relatives or friends you want to financially help with pre-specified limits on what you will give and how much you will set aside for short-term and long-term savings. Importantly, the plan should also include clear instructions on what you won’t spend on, which people you will say no to, and which charities and organizations you will say no to (just about everyone that’s not on your initial donate to list).
You should also do a full assessment of your current financial situation, including all assets, all debts and all expected expenses. Plan on setting aside enough of your windfall to pay off all debts (especially any credit card debt) and to cover your retirement, your children’s education, forthcoming medical expenses and other known liabilities.
After this is done, establish a budget. Doing so might seem silly once wealth is significantly increased, but keeping yourself on allowance is one of the best ways to ensure your money lasts.
Put the Documentation in a Secure Location: This may sound overly simplistic, but don’t overlook its importance. You want to take reasonable steps to ensure your winning lottery ticket or documents related to other sudden wealth are not damaged, stolen or lost. (The prize related to an unsigned lottery ticket can be claimed by anyone who possesses and signs the ticket.) A safe deposit box costs $40 per year here in Chicago and is a very small price to pay to protect your documentation.
Assess Your Insurance Situation: Review your current coverage to ensure you have the right types and enough of it. An umbrella policy can provide protection against personal lawsuits. Life insurance can assist with estate planning. Health insurance may be a reason to not to tell your boss to “take this job and shove it.” Before handing in your resignation, assess the options available on the open market to see if they actually offer the coverage you desire as well as access to the doctors you want to see.
Get a Full Assessment of Your Tax Situation: The tax implications from a sudden increase in wealth extend beyond what you owe on the amount received (which may exceed what is withheld from the initial payment). You may have to undo some tax moves already made for the current tax year (such as contributions to retirement savings accounts). All future taxes could be elevated depending on the amount received. Alternatively, there may be a window to reduce your tax bill for the previous year through such moves as maximizing your IRA or a Roth IRA contribution before April 15. Spending time with a tax professional might yield big benefits.
Finally, realize the role that luck has played. Whether it’s the lottery or business, luck plays a big role in determining outcomes. Even if the big windfall was due to your hard work and creative ideas, various events still had to occur for your good fortune to come true. So take a moment to be appreciative of it, and don’t take your increased wealth for granted.
- 18 Recommendations for Minimizing Inheritance Conflict – Regardless of whether or not you receive a sudden windfall of wealth, proper estate planning can prevent disputes and leave a lasting legacy of love.
- Lump Sum or Annuity: Which Should You Choose at Retirement? – Annuities defend against long life spans, but other sources of income can make lump sums more attractive.
- What Was the Biggest Lesson You Learned From Managing Your Own Wealth? – Whether your wealth came from your savings and hard work and/or another source, tell us what lessons you’ve learned about managing it on the AAII.com Discussion Boards.
There are currently 45 S&P 500 companies scheduled to report earnings next week, mostly mega-caps. Included in this group are Dow components International Business Machines (IBM) and UnitedHealth Group (UNH) on Tuesday; Goldman Sachs Group (GS) on Wednesday; American Express Company (AXP), Travelers Companies (TRV) and Verizon Communications (VZ) on Thursday; and General Electric (GE) on Friday.
The U.S. financial markets will be closed on Monday in observance of Martin Luther King, Jr. Day.
The first economic report of note will be the National Association of Home Builder’s January housing market index, released on Tuesday. Wednesday will feature the December Consumer Price Index and December housing starts and building permits. The January Philadelphia Federal Reserve survey will be released on Thursday. Friday will feature the January PMI manufacturing index flash and January existing home sales.
The Treasury Department will auction $15 billion of 10-year inflation-adjusted securities (TIPS) on Thursday.
January stock options will expire on Friday.
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Optimism among individual investors about the short-term direction of stock prices fell to a nearly 11-year low in the latest AAII Sentiment Survey. At the same time, pessimism rose to a nearly three-year high and neutral sentiment remained above its historical average.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.3 percentage points to 17.9%. Optimism was last lower on April 14, 2005 (16.5%). Bullish sentiment has now been below 30% for seven consecutive weeks and is below its historical average of 39.0% for 43 out of the past 45 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 3.0 percentage points to 36.6%. Neutral sentiment is above its historical average of 31.0% for the 18th consecutive week. Last year, neutral sentiment was above its historical average every week except for two.
Bearish sentiment, expectations that stock prices will fall over the next six months, jumped by 7.3 percentage points to 45.5%. Pessimism was last higher on April 18, 2013 (48.2%). Bearish sentiment has been above its historical average of 30.0% during four out of the last five weeks.
The very low level of optimism is occurring as the stock market has gotten off to a rough start in 2016. As of yesterday’s close, the S&P 500 was in correction territory (down more than 10%). Also playing a role are concerns about the slowing pace of economic growth in China, escalating tensions in the Middle East and frustration with the pace of economic growth in the U.S.
Unusually low levels of optimism (this week’s level ranks among the 20 lowest in the history of our survey) have historically had a stronger association with above-average S&P 500 returns over the following six and 12 months than unusually high levels of optimism.
This week’s special question asked AAII members how concerned they are about the performance of the S&P 500 and the NASDAQ being driven by a relatively small number of stocks. About 40% of respondents said they are not concerned. Some said they are more focused on other issues and other respondents said they invest for the long term. Slightly more than 22% said they are very concerned, with several of these respondents viewing it as a bad sign for the markets. An additional 8% described themselves as being concerned and 5% said they are somewhat concerned.
Here is a sampling of the responses:
- “It shows that these indexes are not representative of the market.”
- “Not at all. I worry about specific stocks, not indexes.”
- “No concern, I dollar-cost-average no matter what the market is doing.”
- “It’s a concern and will contribute to volatility over the next three to six months.”
- “This is a major reason why I am bearish over the next few months.”
Bullish: 17.9%, down 4.3 points
Neutral: 36.6%, down 3.0 points
Bearish: 45.5%, up 7.3 points
Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
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