More Money, More Problems

What if I told you that all that hard work nonsense could be skipped and you could be rich tomorrow? You could be free to do everything you have ever dreamed of. Don’t worry, the next sentence does not contain the word “Bitcoin.” I’m talking about arguably more legitimate (and cheaper) investment opportunities, like the Powerball lottery. Now I am not advocating that Powerball is truly a legitimate investment but we’ve all bought a ticket and dreamed of grandeur at some point in our lives so please hear me out.

When we come into money we have never had, we must plan, not spend, like we never have before. Just because we see more zeros than we’re accustomed to doesn’t mean the money is endless. If you had a plan to drive across the country in a sedan but halfway through you’re given a jet plane, you would definitely need to adjust your plan accordingly and probably read an owner’s manual or two. Odds are we will likely never hit a $500 million Powerball Jackpot, but we may come into a lesser form of instantaneous wealth in our lifetime trough inheritance or other financial windfalls. Be it the lottery, Vegas, or a generous inheritance, there is a process involved in growing, spending, and preserving new-found wealth. As the saying goes, “More money, more problems,” so below we will outline a few concepts and discuss areas where some potential problems may arise when coming into newly acquired wealth.

Annuity Vs. Lump Sum

The decision between taking a lump sum or an annuity payment isn’t just tied to lottery winnings. It can also occur when you have the option to cash out or rollover a defined benefit pension plan. A lump sum is a single payment and can be significantly smaller than the original sticker price. An annuity is the original sticker price paid out in equal amounts over a specified period of time. Below is a quick visual of a lump sum compared to an annuity payment.

The example above is hypothetical in nature, provided for illustrative purposes only, and not indicative of previous client experience. Does not include state taxes.

How can the lump sum be so small? I thought I was winning $500 million? Well, the math can be complicated but it comes down to one principal, present value of future cash flows. In plain English, that means $1 today is worth less and less with each passing year. The folks at Powerball use a discount rate of about 3.7%, meaning they assume the purchasing power of their annual payment will decrease by 3.7% year over year for the next 30 years. So to calculate the lump sum, the question becomes “If I lose purchasing power each year, how much is each annuity payment really worth?” In the above example, the annuity payment is always going to be $16.67 million but the present value falls to $5.81 million by the time you are due the final payment. More specifically, $16.67 million is worth $16.67 million today but only $5.81 million 30 years from now. That is how $500 million becomes $310 million and we haven’t even started talking about taxes!

Electing to receive a lump sum or annuity depends on your personal situation. One benefit of a lump sum option is there is a possibility of earning greater than a 3.7% annual return on the investment. The annuity comes with fewer unknowns as the payments are predetermined. Consulting a financial professional will help in making the right decision.

Income and Estate Taxes

When money is in the conversation, taxes are never too far behind. In the case of the lottery, assuming single tax filer and the jackpot is over $500,000, the maximum federal tax rate of 37% applies. Below is an example of how federal income tax withholding works, assuming a single tax filer electing a lump sum payment of $310 million on a $500 million jackpot before deductions. Bear in mind this example does not factor in state income taxes which can add an additional 0% - 13% depending on the state.

The example above is hypothetical in nature, provided for illustrative purposes only, and not indicative of previous client experience. Does not include state taxes

Taxation on inheritance usually depends on the size of the estate. This form of taxation is known as estate tax and it can be as high as 40% depending on the situation. Imagine the already diminished prize being subject to another 40% tax hit when you pass on your estate to your loved ones. This is why it is critical to work with the proper financial professionals to help develop a plan to preserve your wealth.

Property Taxes

The dream home is often at the top of the list of big time purchases for those with new money. Even though you now have the money, buying on sticker price alone is exceedingly dangerous when other costs of home ownership are not properly accounted for. One of the more expensive parts of homeownership is property tax and the best part is that it must be paid every year! Annual property taxes can range from 1-2% of the home’s value depending on the state. Such a small percentage might not seem like much but a small percentages of a big number is still a relatively big number. Here is an example of what property tax looks like for a beach front home in sunny California.

Maintenance, Repair, and Insurance Costs

There is no feeling like going out and buying something nice for yourself. Indulging in the sweet life is exactly that…sweet. However, there is a price to keeping nice things looking nice. Dream homes are often large and have beautifully manicured landscapes, pools, and gardens. Big expensive homes, just like big expensive cars, are usually more expensive to maintain, repair, and insure. The greater the price tag, the greater the cost of replacement. Maintenance, repairs, and insurance are all recurring costs so just remember to factor them into any home or car buying decision.

Investment Management

Now that we have covered a few of the basic concepts, we will get into the planning before the spending. There are plenty of ways money can be spent irresponsibility. Living on a tight budget helps avoid unnecessary spending but I’m not here to tell you to hoard all your money. I am simply here to help you spend it wisely. New found wealth can be easily wasted due to nothing more than financial inexperience. Before the new wealth, maybe your tax situation may have been simple and your only investing experience came from adding money to a 401k. When navigating unfamiliar territory, it is best to seek the help of a professional. Maybe now you can afford a mistake or two but the greater the funds at stake, the greater the exposure to losses. A reputable financial planner and a CPA are key components in ensuring your money is protected from financial missteps.

Business Ventures

Coming into some new wealth may free you up from the daily grind and allow you to focus on turning something you love into a business. Following your heart and doing what you love are some of the best things you can do in life but there is always a “but.” Whether it be starting your own business or investing in one for a friend or family member, a successful business venture takes careful planning and risk assessment. Avoid impulsive investments and always consult your financial professional before undertaking any major financial ventures.

Traveling

Once you have the means to do so, deciding to travel the world is an easy decision. To manage travel expenses effectively, the first step is to define how much you can reasonably afford in combination with all your other expenses. Once you have established a travel allowance, get on a plane and go. To be clear, I did not say buy a plane, that is unless you are willing and able to pay for the maintenance, fuel, insurance, and hangar fees associated with owning your own plane.

Closing Thoughts

You may have noticed a repetitive message throughout this article and I won’t sit here and say I didn’t plan it that way. You should spend your money, it is yours after all. Just be sure to spend it wisely so it lasts as long as you need it to. The difference between living comfortably without financial anxiety and blowing it all can be just one poor financial decision. With that much on the line, you owe it to yourself to spend a few hours constructing a plan with a financial professional. Regardless of how many zeroes may be on that check, we believe there is no greater asset than being proactive and informed.

The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. Securities offered through Securities America, Inc., member FINRA/SIPC, Betsy Merritt & Tyler Aubrey Representatives. Advisory services offered through Securities America Advisors, Inc. New Break Financial and Securities America are separate companies. Securities America and its representatives do not provide tax or legal advice. It is important to coordinate with your tax or legal advisor regarding your specific situation. Diversification seeks to reduce the volatility of a portfolio by investing in a variety of asset classes. Neither asset allocation nor diversification guarantee against market loss or greater or more consistent returns.