The Powerball jackpot reached $2.04 billion Tuesday morning, making it the world’s largest lottery prize ever. There were no winners for this past Saturday’s drawing, which continued a three-month streak of the jackpot increasing to record levels.
However, by Tuesday, officials in California announced that there was indeed one winner.
With so much money in the jackpot, here’s a look at the most common mistakes individuals make when suddenly coming into a fortune.
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 each year for 30 years that collectively amount to $2.04 billion. Or winners can choose to take a one-time payment—a sum that’s far less than the billions at stake. The immediate cash payment for the $2.04 billion is $997.6 million, according to Powerball.
Taking that one-time payout can be the wrong move, 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 the lump sum payment instead of the annuity, which is hands-down the biggest mistake,” says Pagliarini. "I get it, I understand why. People want the money now. The problem with that is then people can do whatever they want with the money. For some people it’s totally fine—taking 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 when winners make some financial mistakes with their windfall, there’s still another installment payment coming next year and the year after, says Pagliarini.
"You can gift it away, spend it too freely, invest it poorly, and then you get a redo because you get that payment every year for the next 29 years,” Pagliarini says.
There are other benefits of taking the annuity payment as well—the delayed tax burden chief among them. When taking the one-time lump sum payment, winners are required to pay taxes on all of that money upfront. The federal tax bill would likely be 37%, which is the highest tax bracket. And depending on where you live, there will also be state taxes to pay. On winnings of $2.4 billion, the federal taxes alone would amount to about $816,000,000.
But if you opt for annuity payments, you’re paying taxes only on the yearly distributions, which decreases your tax burden substantially. And your final tax payment is not due for 30 years.
Annuity payments can also allow winners to adjust more gradually to their wealth. “Taking the lump sum may give the winner control, but can sometimes overwhelm the winner,” says Michael Liersch, head of the advice and planning for Wells Fargo. "Taking the annuity can help spread the winnings over a longer period of time, helping the winner adapt to newfound wealth.”
2. Overestimating your newfound wealth
Clearly, $2.04 billion—a cash value of $997.6 million—is a lot of money. But even when you’re talking about such large numbers, winners end up thinking they have more money to burn through than they actually do.
Those who take the lump sum payment will have their winnings cut nearly in half by immediate tax bills, says Pagliarini. What's more, if you're not the sole winner of the big jackpot, the amount you stand to receive is reduced even further. When there are multiple winners, the jackpot is divided evenly among them all.
“If there are two winners, the prize gets split 50-50 and so on,” Pagliarini explains. All of which means the amount of money you end up with is likely to be less than you actually think.
The key point here is that it’s important to hold off on spending until you understand the exact amount of winnings you’ll actually receive and the tax burdens associated with that money. It’s a good idea to immediately contact a tax professional to help sort through these questions and help you plan appropriately.
3. Treating winnings like Monopoly money
When you win millions of dollars, the money may not even seem real, making you feel more comfortable about spending it freely, without much thought. Some financial advisers describe this as viewing the money like Monopoly money, a reference to the popular board game.
What's more, there are a variety of emotions wrapped up in money and how we handle spending choices. Allowing emotions to drive spending and decision-making as a lottery winner can be a downward spiral, one that may even lead to bankruptcy.
“The Monopoly-money mindset knows no boundaries. It’s hard for many to control their material desires. Having a red Ferrari is great, but it would also be nice to have a blue one,” says Philip Richter, cochairman, president, and partner of Hollow Brook Wealth Management, a firm that provides wealth management including investment management and tax and estate planning. “The consumptive nature of modern American society can drive many of us to want more and more even if our life is already abundant. If one did not grow up in a privileged world, it is tempting to not only keep up with the Joneses, but exceed them by a wide margin.”
Pagliarini agrees, pointing out that because it's such an enormous amount of money, it simply does not seem tangible to people.
"Because you didn’t earn it and you know you didn’t earn it, you are going to treat it differently. It’s not going to hold the same gravitas as if you earned it. You're going to spend it more freely, give it away more freely, and make riskier investments," says Pagliarini.
The best way for lottery winners to avoid this Monopoly-money pitfall 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 adviser will say no to frivolous spending and will draft 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 next mistake:
4. Not consulting with financial professionals
Handling the level of cash associated with a Powerball jackpot is a once-in-a-lifetime occurrence for the average individual. But for some people, such as wealth managers, CPAs, financial advisers and the like, managing enormous sums of money is what they do day in and day out.
If you happen to be among the lucky winners, 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 make and how to budget the money.
"That team should include an attorney, a tax person, and a financial person,” says Pagliarini. “You want to work with people who have experienced 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 major purchases like a car or house you previously couldn’t afford. These sorts of purchases are examples of lifestyle creep, which is when an increase in income leads to excessive discretionary spending. But all of those new possessions can also be expensive to maintain and increase your cost of living.
"Having unbridled access to hundreds of millions of dollars provides unlimited opportunities…planes, helicopters, racehorses, and multiple homes suddenly are not only within reach, they are a tangible reality,” says Richter. "These types of luxury assets require enormous upkeep and generate significant ongoing expenses.”
In other words, building empires made up of multiple homes, cars, and other major purchases can lead to expenses that ultimately exceed your financial capabilities—even as a lottery winner.
"People really try to change their lives too much.They feel like they need to upend everything just because they have all of this money,” says Pagliarini. “But you don’t have to do that.”
Instead, figure out what’s worked well for you in the past, what you enjoy and what you get pleasure from. And focus on those things. “Try to use money to improve your life rather than radically upend it,” says Pagliarini.
