The Powerball jackpot continues to grow and has now reached nearly $2 billion, making it the largest lottery prize in the world. There were no winners for last Saturday’s drawing, thus continuing the current three-month streak of continued jackpot growth.
The next drawing is tonight, offering another shot at a windfall of $1.9 billion. With so much money at stake, here’s an overview of the most common mistakes people make when they suddenly become rich.
1. Choosing a lump sum payment instead of an annuity
Jackpot winners have two choices when it comes to how they wish to receive their payout. The options include annual installment payments every year for 30 years, which in this case would be $63 million, an amount that totals a jackpot of $1.9 billion.
Or, alternatively, winners could choose to receive a lump sum – an amount far less than the billions now at stake. Those who choose an immediate cash payment will receive $929 million.
Taking that lump sum, however, could be the wrong move, he says Pacifica Wealth’s Robert Pagliarini, a certified financial planner and investment manager who specializes in working with lottery and Powerball winners.
“People almost always choose a lump sum payment instead of an annuity, which is the biggest mistake,” Pagliarini says. “I get it, I get why. People want the money now. The problem with that is that then people can do whatever they want with the money. For some people, it’s perfectly fine – to take a lump sum – unless you make some mistakes. And what we know about lottery winners is that they don’t make the best financial decisions.
The advantage of taking the annuity is that even if the winners make some financial mistakes with their windfall, there will still be another $63 million next year, Pagliarini says.
“You can give it away, spend it too freely, invest it badly, and then get repaid because you get that payment every year for the next 29 years,” Pagliarini says.
There are other benefits to taking an annuity payment – the deferred tax burden being chief among them. When they take the lump sum payment, winners must pay taxes on all of that money upfront. That’s a 37% federal tax rate, and depending on where you live, there will also be state taxes to pay. On profits of $1.9 billion, federal taxes alone would amount to just over $700 million.
However, when you choose annuity payments, you only pay taxes on the $63 million in annual distributions, significantly reducing your tax burden to about $23,310,000 per year. And your last tax payment is not due for 30 years.
Annuity payments can also allow winners to adjust their wealth more gradually. “Taking the lump sum can give control to the winner, but sometimes it can overwhelm the winner,” says Michael Liersch, Wells Fargo’s head of advice and planning. “Taking the annuity can help spread the gains over a longer period of time, helping the winner adjust to newfound wealth.”
2. Overestimating your newfound wealth
Apparently $1.9 billion – a monetary value of $929.1 million– that’s a lot of money. But even when you’re talking such big numbers, the winners end up thinking they have more money to burn than they actually do.
“Even if the lottery jackpot is $1.9 billion, the winners don’t actually have $1.9 billion,” Pagliarini explains. “If you made the mistake of taking the lump sum, that cuts your earnings in half to about $800 million. After paying taxes, you probably have about $400 million. So you immediately went from about $1.9 billion to $400 million.
And none of that math takes into account the possibility that you might not be the only big jackpot winner. When there are multiple winners, the jackpot is split equally between all of them.
“If there are two winners, the prize is split 50-50 and so on,” explains Pagliarini. All this means is that the amount of money you will receive will probably be less than you actually think.
The key point here is that it is important to hold back on spending until you know the exact amount of profits you will actually receive and the tax burden associated with that money. It’s a good idea to contact a tax professional right away to help you sort through these questions and help you plan appropriately.
3. Treating winnings as Monopoly money
When you win millions of dollars, the money may not even seem real, which makes you feel more comfortable spending it freely without thinking too much. Some financial advisors describe this as looking at money like Monopoly money, a reference to the popular board game.
What’s more, there are different emotions wrapped up in money and how we approach our spending choices. Letting emotions drive your spending and decision making like a lottery winner can be a downward spiral that can even lead to bankruptcy.
“Monopolistic thinking about money knows no bounds. Many find it difficult to control their material desires. Having a red Ferrari is great, but it would be nice to have a blue one as well,” says Philip Richter, co-chairman, president and partner of Hollow Brook Wealth Management, a firm that provides wealth management, including investment management and tax and estate planning. “The consumerist nature of modern American society can leave many of us wanting more and more, even if our lives are already abundant. If one hasn’t grown up in a world of privilege, it’s tempting to not only keep up with the Joneses, but outdo them by a wide margin.
Pagliarini agrees, pointing out that because it’s such a huge amount of money, it just doesn’t seem tangible to people.
“Because you didn’t earn it and you know you didn’t, you’re going to treat it differently. It won’t carry the same weight as if you had earned it. You’ll spend it more freely, give more freely and make riskier investments,” Pagliarini says.
The best way for lottery winners to avoid this monopoly money trap is to have a trusted investment professional as your partner who, as your fiduciary, will look out for your best interests at all times. “This trusted advisor will say no to frivolous spending and create a rigorous, quantitative and ongoing financial plan that takes into account income, expenses, risk and asset allocation,” adds Richter.
A financial plan developed by a professional will outline what can reasonably be spent on a monthly, quarterly and annual basis. Which brings us to the following error:
4. Do not consult with financial specialists
Dealing with the level of money associated with the Powerball jackpot is a once-in-a-lifetime occurrence for the average person. But for some people, like wealth managers, CPAs, financial advisors and the like, managing huge sums of money is what they do every day.
If you happen to be among the lucky ones, be sure to immediately surround yourself with a team of experienced experts who can help you successfully manage your financial future, including advising you on the wisest investments to do and how to budget the money.
“That team should include a lawyer, a tax person and a finance person,” Pagliarini says. “You want to work with people who have been through this dozens if not hundreds of times. And you want to rely on them.”
5. Falling victim to lifestyle creep
With millions—or sometimes even billions—of dollars suddenly at your fingertips, it’s only natural to be tempted to splurge on big purchases like a car or house that you couldn’t afford before. These types of purchases are examples of lifestyle creep, where an increase in income leads to excessive discretionary spending. But all those new possessions can also be expensive to maintain and add to your living expenses.
“Unrestricted access to hundreds of millions of dollars provides limitless possibilities…airplanes, helicopters, racehorses and multiple homes are suddenly not just at your fingertips, they’re a tangible reality,” says Richter. “These types of luxury assets require huge maintenance and generate significant running costs.”
In other words, building empires made up of multiple homes, cars, and other large purchases can result in expenses that ultimately exceed your financial means—even as a lottery winner.
“People really try to change their lives too much. They feel they have to turn everything around just because they have all this money,” Pagliarini says. “But you don’t have to do that.”
Instead, find out what has worked well for you in the past, what you like, and what you get pleasure from. And focus on those things. “Try to use the money to improve your life instead of radically changing it,” Pagliarini says.
This story was originally featured in Fortune.com
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