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What Is a Lump-Sum Payment?
A lump-sum payment is a monetary sum paid in one single payment instead of allocated into installments. Lump sums are commonly associated with pension plans and other retirement vehicles, such as 401(k) accounts, where retirees might accept a smaller upfront lump-sum payment rather than a larger payment issued in installments over time.
Key Takeaways
- A lump-sum payment is an amount paid all at once, as opposed to an amount that is paid in installments.
- A lump-sum payment is not the best choice for everyone. For some, it may make more sense for the funds to be annuitized as periodic payments.
- Based on interest rates, tax situation, and penalties, an annuity may end up having a higher net present value (NPV) than the lump-sum.
Understanding a Lump-Sum Payment
Lump-sum payments can describe a bulk payment to acquire a group of items, such as a company paying one sum for the inventory of another business. Lottery winners will also typically have the option to take a lump-sum payout versus yearly payments.
Annuities provide a degree of financial security, but an older retiree in poor health might derive greater benefit from a lump-sum payment. Securing an upfront payment often guarantees an asset to pass on to your heirs.
An upfront payment might enable you to buy a house or other large purchase that you would otherwise not be able to afford. Similarly, you can invest the money and potentially earn a higher rate of return than the effective rate of return associated with the annual payments.
Lump-Sum vs. Annuity Payments: An Example
To illustrate how lump-sum and annuity payments work, imagine you win $10 million in the lottery. If you take the lump-sum payment, the entire winnings would be subject to income tax in that year, and you would be in the highest tax bracket.
However, if you choose the annuity option, the payments could come to you over several decades. For example, instead of $10 million in income in one year, your annuity payment might be $300,000 a year.
You would avoid the highest federal income tax bracket of 37% for single people with incomes greater than $609,350 in 2024 ($626,350 in 2025), or $731,200 for married couples filing jointly in 2024 ($751,600 in 2025).
Such tax questions depend on the size of the lottery win, current income tax rates, projected income tax rates, your state of residency when you win, in which state you will live after your win, and investment returns. But if you can earn an annual return of more than 3% to 4%, the lump-sum option usually makes more sense compared to a 30-year annuity.
Which Is Better, a Lump Sum or an Annuity?
There are pros and cons to accepting a lump-sum payment rather than an annuity (fixed payments over a period of time). The right choice depends on the value of the lump sum versus the periodic payments and one’s financial goals.
It is not always best to take the lump-sum payment in lieu of periodic annual payments; if offered the choice, consider taxes, investments, and the net present value (NPV), which accounts for the time value of money.
Is a Lump Sum Risky?
Receiving a lump sum payment is not necessarily risky. However, if you receive it as physical cash, security may be an issue. It may also be risky to deposit the lump sum in one investment option (such as a single stock), rather than diversifying your investment. Diversification reduces risk.
Why Is It Called Lump Sum?
A “lump,” according to Merriam-Webster, is an adjective that means “not divided into parts”, or “entire.” A “sum,” according to the dictionary, is “an indefinite or specified amount of money” or “the whole amount,” or “aggregate.” As a term, “lump sum” means “an amount of money that is paid at one time” or “a single sum of money.”
The Bottom Line
A lump-sum payment might be an option in multiple situations. In mortgage lending, a “bullet repayment” is the lump-sum of the outstanding loan paid to a lender. More commonly, you may have a lump-sum option with a pension.
A lump-sum comes with pros and cons. One advantage is that with a lump sum, you have more control up front, and once you receive it, you can invest the money however you wish. However, you may receive less money in a lump sum than you would have if you took periodic payments. Taxes are also a concern.
This is a situation where it’s a good idea to choose carefully. If you have any questions, consider reaching out to a financial advisor.