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Here are the pros and cons of a lump sum vs annuity.

If you’re lucky enough to win the lottery or have a pension plan, you may need to decide whether you want to take your earnings in a lump sum or an annuity. And if your goal is to maximize your earnings, you may want to take into consideration your projected lifespan, inflation rates, and your own spending and investing habits. We break down the difference between a lump sum and an annuity, plus offer examples to help you decide which one you should take.

Lump Sum vs. Annuity

A lump sum is often a payment that is paid out at once rather than through multiple payments paid out over time. A lump sum allows you to collect all of your money at one time.

An annuity is often a steady payment that is made at equal intervals, such as monthly or annually. An annuity allows you to collect part of your money every month or year over a longer period of time.

The Pros and Cons if You Have a Pension

If your employer offers a traditional defined-benefit pension plan, you may have to make a tough choice when you hit retirement. Should you take a lump sum or choose monthly annuity payments for the rest of your life, and maybe for the life of your spouse and/or beneficiaries’ lives? Before deciding, let’s look at the pros and cons of both instances.

Pros of taking the annuity:

Cons of taking the annuity:

  • Annuities might give you less financial flexibility in life
  • You may die before ultimately collecting all of the retirement money you’re owed
  • Some annuities may not pay benefits to your family or beneficiaries in death
  • The annuity might be too small to cover your medical bills if you are very sick

Pros of taking the lump sum:

  • If you have large debts, you can pay them off quickly
  • You can pass on whatever is left of the lump sum as an inheritance
  • You can invest large amounts of the money sooner

Cons of taking the lump sum: 

  • Your retirement money could run out before you die if not managed properly

Analyzing Your Options

Here are the pros and cons of a lump sum vs annuity.

After weighing the pros and cons, it’s still smart to analyze your own situation. A simple analysis compares the monthly payment amount offered with what you believe you could generate by investing this lump sum at about the same risk level. There are three factors to consider with this analysis.

1. Life Expectancy

Life expectancy is the most important factor of the three.

If you’re healthy, or have a good reason to believe that you or your spouse will live beyond the average life expectancy, monthly payments might be more attractive to you. If your spouse is significantly younger than you, that also might play a role in your decision. However, unless you choose a survivor benefit or term certain option, your annuity payments will stop when you die. The survivor benefit allows your heir to receive the annuity payments for their life span after you die. The term certain option offers you payments that decrease a little every month, but that will continue to your heirs in the case that you die.

However, if you’re in poor health and don’t expect to live beyond the average life expectancy, or you retired later in life, you may get more out of the lump-sum option. A lump sum can be passed on to your heirs. And while managing that lump sum, it may be smart to overestimate how long you will live. Running out of money at age 95 because you thought you would only live to 80 is not a fun prospect.

2. Return on Investments

If you already have a sufficient retirement income – whether through Social Security benefits, other existing annuities or other forms of lifetime income – you could take either the annuity payments or a lump sum and invest the money for yourself or your heirs.

Some companies offer a partial annuity, which would allow you to take part of your pension as a lump sum and part as an annuity. If your company doesn’t offer that, you could take the lump sum and purchase your own fixed annuity through a private company. You might be able to find an annuity plan that will guarantee you more money than your pension program. Another option is putting part of the lump sum towards an annuity, and investing or spending the rest of the lump sum however you choose.

It might also be a good idea to take the lump sum and roll it over to an individual retirement account (IRA). A direct rollover to your IRA from your employee’s plan is not subject to immediate taxation and can preserve the tax-deferred status of this money, while allowing it to be invested.

3. Risk of Return

If you are concerned about the reliability of your retirement income, you might want to take the annuity for the security. If a lot of your retirement income is dependent upon the market rather than guaranteed, the security might be a better bet for retaining a certain minimum lifestyle.

However, if you’re choosing the annuity payout for the security, you should check the credit rating of the pension fund or annuity provider. The Pension Benefit Guaranty Corporation (PBGC) is a federal government agency that provides limited protection for some private sector pension participants. If you’re really concerned about losing your pension because of the pension provider’s financial situation or inability to pay out, taking the lump sum may end up being the more secure option.

If your annuity does not have a cost-of-living adjustment, it’s purchasing power will decrease over time due to inflation. You can invest a lump sum in low-risk stocks, bonds or securities to help your assets keep up with inflation. However, doing so does involve taking on some market risk and doesn’t mean that income will last for the rest of your life.

The Pros and Cons if You Win the Lottery

While those with a pension plan may have until retirement to decide, lottery winners have to choose quickly if they are taking a lump sum cash option or yearly annuity payments. Let’s look at the pros and cons of both options.

Pros of taking the annuity:

  • Annuity payments typically end up being a larger amount than the lump sum
  • Some annuity payments may be taxed at a lower rate

Cons of taking the annuity:

  • Annuities might give you less financial flexibility in life
  • You may die before ultimately collecting all of the money you won

Pros of taking the lump sum:

  • You can use the money right away and however you choose, such as investing it

Cons of taking the lump sum:

  • The lump sum payment will be less money than the reported jackpot because the total amount is subject to income tax for that year and there’s a deduction for taking the lump sum payment
  • Your money could run out if not managed properly

Analyzing Both Options

As with a pension, it’s important to analyze both options according to a few different factors.

1. Life Expectancy

If you choose the annuity option, you will either get equal payments for a period of time, or inflation-adjusted payments for a period of time. This could offer you more financial security for years to come.

For example, if you take the annuity and end up spending a year’s worth of money in six months, you get a chance to start over the next year with your next annuity payment and learn from your mistakes. Or if you’re young, you might prefer the extended payouts, since you’re going to live a lot longer and may want to guarantee a comfortable standard of living.

If you’re older, you might want the lump sum of money now and enjoy it in your sunset years. Additionally, if you have kids, keep in mind that if can choose the extended payout, which means your heirs receive the remaining installments when you die.

2. Return on Investments

On the other hand, if you’re a good investor, or work with a good brokerage or financial advisor that you trust, you can potentially turn that lump sum of money into much more through investments. The amount could end up growing to be more than the initial jackpot winnings and what you would have taken home through had you chosen the annuity.

As with the pension money, you could also take the lump sum and purchase your own fixed annuity through a private company. There is the possibility of a higher return when you purchase your own annuity than when taking the lottery annuity. You could also try investing in low volatility, dividend-paying stocks, and effectively create your own annuity.

Even if taking the lump sum is theoretically a good investment decision, it might not be a better decision for you. Many lottery winners end up taking the lump sum and spending all their money in a few years. Taking the annuity option gives yourself time to figure out how you want to manage your money, and protects you against yourself as well as anyone who might take advantage of you.

The trade-off ends up being between security and maximizing your winnings.

The Bottom Line

Here are the pros and cons of a lump sum vs annuity.

Whether you’re receiving a large sum of money from your pension plan or lottery winnings, it’s important to analyze both payout options before choosing the lump sum or annuity. While an annuity may offer more financial security over a longer period of time, a lump sum could be invested, which could offer you more money down the road. If you take the time to weigh your options, you’ll be sure to choose the one that’s best for your financial situation.

Tips for Maximizing Your Money

  • Whether it’s your pension or lottery winnings, it may be smart to consult a financial advisor to help you make the best decisions for your future. Finding the right one that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • If you receive a large sum of money, be sure to budget accordingly. Consider creating a completely new budget and adjusting your financial goals. The extra money may help you pay down debt faster and build an even larger emergency fund, which will help you save even more in the long run.
  • While it may be intimidating, investing your money is one of the best ways to potentially grow it over time. From stocks and bonds to ETFs and mutual funds, there are several places to invest your money. You can start today with an online brokerage account or robo-advisor and invest your money from the comfort of your own home.

Photo credit: ©iStock.com/FabrikaCr, ©iStock.com/Geber86, ©iStock.com/PeopleImages

Sarah Fisher Sarah Fisher has been researching and writing about business and finance for years. She has worked for the Consumer Financial Protection Bureau and her work has appeared on Business Insider and Yahoo Finance. Sarah has a bachelor's degree from Georgetown University and is from New York City. When she isn't writing finance articles, she dabbles in animation and graphic design.
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