Powerball fever has broken. Someone in California won the jackpot, which was worth just over $1 billion, the third-largest Powerball prize in the lottery’s history. Maybe there’s something about the place, the largest Powerball jackpot ever, for $2.04 billion, also occurred in the Eureka state, in October 2022. In the days leading up to the drawing, there were plenty of articles recounting the terrible odds (1 in 292.2 million) of hitting the jackpot, but as the lottery operator likes to remind us, “The overall odds of winning a prize are 1 in 24.87.”
You might think that I am about to launch into a lecture about the ills of lotteries, but I assume that you know that playing numbers, gambling, or day trading when you don’t know what you are doing or for anything other than a fun way to dream, can be detrimental to your financial and emotional life. Instead, let’s use Powerball as a teaching moment, a way to discuss some core investment and financial planning concepts. (Full disclosure: I come to the discussion of big winnings after a unique experience. More than two decades ago, when I was a practicing financial planner, I had a client who was the lucky winner of an $80 million prize.)
But you don’t need an unexpected windfall to be in the millions to prompt action. A surprisingly large bonus, an inheritance, or a bigger than expected sale price on a house or stock can be a catalyst to rethink where you are in your life. Importantly, the new-found money may cause you to rethink previous decisions and alter your goals. Here are some of the specific steps that can help.
- Draft Your Professional Team: A windfall that changes your life may mean that it’s time to interview estate attorneys, accountants, and financial advisors. If you are already working with any of these professionals, it may be worth it to reconsider that you are with the right person/firm for your current situation. Check out my 13 Questions you should ask before hiring a financial advisor.
- Create or Update Your Financial Plan: So many people plunge into investing without understanding what they are trying to accomplish. According to the CFP Board, the planning process involves 7 steps: Understanding a client’s personal and financial circumstances, Identifying and selecting goals, analyzing the current course of action and potential alternative courses of action, developing recommendations, presenting those recommendations, implementing the plan, and monitoring/updating ?progress.
- Consider Taxes: Part of the planning process will incorporate taxes, but before your dreams take off, remember that Uncle Sam is often a partner in your windfall. Consider that the recent $1 billion Powerball winner might be focusing on that B of billion, but the headline number is PRE-TAX. If the winner chooses a lump sum (more on that below), the amount would be about $558 million. To make sure that the bulk of the taxes are paid, the lottery operator will withhold 24 percent, or about $134 million. Chances are, the winner will have to pay even more in taxes, because the windfall will mean that the top tax bracket of 37 percent will be applied and depending on your state of residence, there could also be state taxes.
- Tax considerations are important in any transaction. For example, the sale of a primary residence may allow you to exclude up to $250,000 of a capital gain from your income, ($500,000 if filing jointly), but with the explosion of real estate prices in the past few years, many will find that they exceed that gain. Or if you sell company stock that was granted to you, there could be either a long term or short-term capital gain tax that is due.
- Determine whether you will take a lump sum or an annuity. This decision is one-part math and one-part emotional. Usually, a big chunk of cash invested over time will accumulate faster than smaller amounts invested at regular intervals. (This is a good thing to keep in mind when you are considering whether to?pull the trigger with money on the sidelines or dollar cost averaging.) Additionally, while 37 percent sounds like a high bracket, by choosing a lump sum, you are locking in your tax liability at historically low tax rates.
But receiving money all at once risks blowing some or all of it by doing dumb things, like investing in your cousin’s hair-brained business idea or buying too much, too fast. The stream of income ensures that you won’t plow through your jackpot, which may make the annuity option a better one for some winners. From an estate perspective, the Powerball annuity is an "annuity certain," meaning that the payments are still made if the winner dies before the 30th year. In this event, the remaining payments would go to the winner's estate, and would pass on to their heirs.