Investopedia
August 11, 2017
Alex Kulick
Feeling lucky? You'd better be, if you play the lottery. Depending on which one you play, you have some pretty
long odds. For example, the odds of winning a recent Powerball drawing in Tennessee was 1 in 292.2 million. To
put this in perspective, you have a one in 2,320,000 chance of being killed by lightning, a one in 3,441,325
chance of dying, after coming into contact with a venomous animal or plant and a one in 10 million chance of
being struck by falling airplane parts. Most people would agree, the risk of any of these events actually
happening to them is pretty slim.
Let's look at it another way! Assume, you went to the largest stadium in the world (which happens to be in
North Korea)! The stadium was filled to capacity. As part of the price of your ticket you were entered into
a lottery, where you could win a new car. In that case your odds of winning are 1 in 150,000.
Would you be sitting on the edge of your seat in that stadium, as they're reading the ticket number or would
you believe, that realistically you're not going to win? To equal the odds of winning the lottery, you would
have to fill that same stadium to capacity 833 more times and put all of those people together and have the
same drawing for the one car. Would anybody believe, they could actually win in a crowd of people that large?
Still not convinced? If they were giving away a new home to just one person and everybody in the six most
populated states in the United States entered, that would equal your chances of winning the lottery.
Independent Probability
Of course, someone has to win the lottery and the only way to win it is to be in it, as the ads say. But what's
the best way to be in it? The rules of probability dictate, you do not increase your odds of winning the lottery
by playing frequently. Each time, you play the lottery, there is independent probability — much like a coin toss,
where each and every toss, regardless of the number of tosses, has a one in two probability of landing on heads.
The odds stay the same in the lottery and the coin toss, regardless of the frequency of playing.
You can, however, increase your odds by purchasing more tickets for the same lottery drawing. Keep in mind, though,
that two tickets might increase your odds from one in 14 million to two in 14 million, which is not a significant
improvement statistically speaking. Someone would have to buy a lot of tickets to appreciably increase their odds
of winning. Even if a person could afford to, however, he or she could not buy enough lottery tickets to guarantee
a win, unless he or she was the only person buying the tickets. As more tickets are collectively sold, the odds of
winning inversely decrease.
Who Plays the Lottery?
Your chances of winning the lottery are exceedingly remote, but that doesn't stop people from playing. Overall,
approximately 57% of U.S. adults collectively will spend upwards of $50 billion each year in the hopes of striking
it rich (Canadians spend more, than $8 billion per year). Time and again, when a lottery was introduced in a state,
the local number of adults, who engaged in gambling (which a lottery technically is), increased 40%. In certain
states the majority of lottery revenue comes from a small percentage of players. A Minnesota study, for instance,
determined, that 20% of its lottery players accounted for 71% of lottery income and in Pennsylvania 29% of players
accounted for 79% of income, according to the North American Association of State and Provincial Lotteries (NASPL).
So what? The lottery is just one of those fun things, that we do as a way to strike it rich, right? For some folks
that's true, but for others, often those with the least amount of money to spare, playing for these jackpots can be
a serious income drainer. An overwhelming amount of lottery participants seem to reside in the lower economic classes,
according to the stats. In California a study found, that 40% of those, who played the lottery, were unemployed. In
Maryland the poorest one-third of its population buys 60% of all lottery ticket; and in Michiga, people without a
high school diploma spent five times more on the lottery, than those with a college education. Small wonder, that
consumer-finance gurus say, the lottery is essentially an extra tax on the poor.
Gambling vs Investing: Which Has the Better Odds?
A curious headline was placed on the homepage of the Mega Millions website on March 25, 2011: a day, when the odds
of winning had gone up to 1 in 175 million (1,166 stadiums, in case you were wondering). The headline read, "Save
for Retirement!" Anti-gambling groups cried foul at this apparent attempt to spin the lottery as a means to fund a
person's post-work years and lottery officials quickly issued a statement saying, they were running a campaign
encouraging people to dream about how they would use their winnings, not offering a financial strategy.
Is there a better, more profitable way to spend or invest the money, you'd otherwise devote to the lottery? Let's
look at the numbers! If a person spends $5 per week on lottery tickets, it adds up to $260 per year. Over 20 years
(a typical long-term investment horizon for stocks and bonds) the total spent on lottery tickets would be $5,200.
Putting $260 per year into stocks earning 7.3% annually (based on equities' historical performance) yields $11,015
after 20 years. But if you just spent the money on lottery tickets and presumably won nothing, you would be out
$5,200 after 20 years.
Of course the stock market is never a sure thing: stocks can depreciate as well as appreciate. So let's try a more
cautious estimate! One study in Texas found, a person without a college degree spent an average of $250 per year
purchasing lottery tickets. If that same person were to start an IRA or other retirement account, that earned a
conservative average 4% annual return and contributed that same $250 to it per year for 30 years, he or she would
have $15,392, once they reached retirement age. If they did the same thing for 40 years, that number would jump to
more, than $25,000.
Although some would argue, that in today's economy there is no way to guarantee, that the money would earn 4%,
there's also no guarantee, that it wouldn't earn far more, than 4%. But all of that aside, the odds of having
$15,000 after 30 years are largely in the person's favor. Certainly more so, than with the lottery's
125-million-to-1 odds.
Lottery Winnings: Lump Sum or Annuity?
Let's say, despite the dismal odds you do win the lottery and you win big—six figures big. You're going to face
a lot of decisions and the first one is, how to receive the funds. With most lotteries you get a choice: They can
write you a check for the lump sum amount or you can opt to receive it in the form of an annuity. The lump sum is
a single cash transfer, whereas the annuity is a series of annual payments (often spread out over 20 to 30 years).
Unlike some annuities, that end, when you do, this is something called an annuity certain: The payouts will continue
for the set term of years, so if you pass away, you can bequeath those payments to whomever you would like. Which
should you take?
The Case for the Lump Sum Payment
Most lottery winners opt for a lump sum payment. They want all of the money immediately. That is the main advantage
of a lump sum: full and complete access to the funds. Not only do individuals like that, but their newly acquired
giant team of accountants, financial advisors, money managers and estate lawyers do, too: the more assets under
management, the better! Especially, if their compensation is based on a percentage of those assets.
Taking a lump sum could also be the better course, if — not to be morbid — the winner isn't likely to live long
enough to collect decades of payouts and has no heirs to be provided for.
Tax Advantage: Annuity
However, you may be in a better income tax position, if you receive the proceeds over several years via an annuity
rather, than up front. Why? Lottery wins are subject to income tax (both federal and state, except for the few
states, that don't tax winnings) in the year, you receive the money. Say, you win a $10 million jackpot. If you
take the lump sum option, the entire sum is subject to income tax that year. However, if you choose the annuity
option, the payments would come to you over several decades and so would their tax bill. For example, in a 30-year
payout schedule, instead of $10 million all in one year, you'd get around $333,000 a year. Although that $333,000
would be subject to income tax, it could keep you out of the highest state and federal income tax brackets.
But even if you pay the taxes all at once, it’s roughly the same as paying them over time, isn’t it? Not according
to the experts.
If you choose the annuity option, the government takes your winnings and invests them for you — most likely in
boring, yet highly stable Treasury bonds. Usually when you invest, you pay taxes. But when the government invests,
it does so tax-free. So over 30 years not only are you getting a monthly payment on your winnings, you’re also
earning investment income on them.
Let’s say, you opted for annuity payments on a $327.8 million prize and you’re invested in a 30-year government
bond paying 4.5% interest. In your first year you’ll earn an estimated $14,715,000 in interest. By the end of the
20 years your winnings would be 20% higher, than when you started. All, you have to do, is be OK with having
somewhere around $900,000 as a monthly payment after taxes (assuming, you're in the maximum federal tax bracket,
which you surely will be).
Here’s the other advantage: If you take the lump sum, you effectively have to pay taxes twice: once when you get
the check and then again on the income, you earn from investing it yourself (you will invest most of it, right?).
If the government invests it, you only pay a tax bill once (on the annuity checks).
Other Advantages to Annuities
But perhaps the biggest argument for taking the annuity is more intangible: to protect you from yourself. A
six-figure windfall is a life-changing event and not necessarily a good one. Most people are inexperienced at
managing such sums to begin with, but even the wisest and coolest of heads could lose perspective, especially
given the avalanche of friends, family and even strangers, that descends, once the news gets out, pleading or
even demanding a share of the spoils. Academics cite research showing, most lottery winners will save only 16
cents of every dollar, they win. In fact, lottery winners' bankruptcy rates soared three to five years after
their big coup.
An annuity can help by literally limiting the funds in your possession: you can't give away, squander or otherwise
mishandle, what you don't have. Plus, taking the money over time provides you with a "do-over" card. By receiving
a check every year, even if things go badly the first year, you will have many more chances to learn from mistakes,
recoup losses and handle your affairs better.
The Inheritance Factor
There is a big first-world problem, that comes with the annuity, though. If the payments are still coming in, when
you die, your heirs have to pay estate taxes on the money, the entire amount, that's left. They might not have the
cash on hand to do so. Powerball has an answer, if your state allows it: Upon your death it will convert your annuity
into a lump-sum payout. At least then the tax bill can be covered without forcing anyone into bankruptcy.
The Bottom Line
If you ever do win the lottery, you will want to work with your financial advisor, tax attorney and CPA to determine,
which option is best for you: taking the winnings all at once or in annuitized payments over decades. As a rule of
thumb, if you and your money-management team think, they can invest to earn an annual return of more, than 3% to 4%,
the lump sum option makes more sense over the annuity at the end of 30 years.
Many people see purchasing lottery tickets as a low-risk investment: Where else can you "invest" $1 or $2 for the
opportunity to win hundreds of millions of dollars? The risk-to-reward ratio is certainly appealing, even if the
odds of winning are remarkably small. Is it better then to play the lottery or invest the funds? There is no one
universally correct answer. Much of it depends on what money is being spent. If it is needed for retirement or the
kids' college, it may make more sense to invest: A payoff is more certain down the road, even if it doesn't amount
to a sexy six-figure check. If, however, the money is tagged for entertainment and you would have spent it seeing
the latest movie anyway, it might be fun to take the chance. Keeping in mind, of course, that you are more likely
to die from a snake bite, than to ever collect.