What Is a Lump-Sum Payment?
A lump sum payment is a big payout that you receive all at once. It’s often used for settlements with insurance companies, pensions, and other retirement plans.
Benefits of Lump Sum Payments
The benefits of receiving a lump sum payment include:
- You receive all your money at once instead of overtime which is called an annuity.
- You can invest your money in riskier investments but have a higher return, like stocks or high-yield bonds.
- You can use the money to pay off any debt.
- You can use the funds to cover living expenses like rent, groceries, and bills.
- You have more flexibility with spending your lump sum payment than an annuity, which is limited by what it pays out every month.
- You can pay for a big purchase or upgrade that you might not be able to afford with an annuity.
When Should You Choose to Take a Lump Sum Payment Rather Than an Annuity?
One of the most common financial decisions is choosing between receiving a lump sum payment or an annuity.
The decision to take a lump sum depends on your personal needs and goals, as well as how much risk you’re willing to take.
If you know that you’ll need money for emergencies and want to avoid taking out loans, it might be wise to choose the annuity option.
On the other hand, if you don’t anticipate any major expenses in retirement but would rather have some extra cash now, then a lump sum payment could make more sense for your situation.
There are many instances where it might be beneficial for someone to receive a lump sum payout instead of an annuity.
For example, if the individual is not going to live much longer and wants their beneficiaries to have cash as soon as possible, they may want to take a lump sum payment.
This gives them the flexibility to invest the money as they please and spend it however they see fit before their passing, rather than tying up their cash in an annuity contract that only provides certain benefits for life.
Lump Sum Payment Example
To give you a better idea of what lump sum payments are, here is an example:
Joe was in a car accident and received $100,000 from his insurance company. He’s been told that he should choose between accepting the money as either a lump sum payment or an annuity payment over 20 years.
At first glance, Joe might think taking the lump sum seems like the way to go because it gives him more flexibility with his money.
But Joe decides to do some research and learns that if his investments don’t work out, the annuity still provides him with guaranteed payments for 20 years.
Risks of Taking a Lump Sum Payment Over an Annuity
Although there are many benefits to receiving your money all at once, there are also some drawbacks that you need to consider.
- The risk involved with investing your entire payout in high-yield investments instead of being guaranteed steady payments for life. Lump sum payments are a much bigger risk than annuities because they don’t guarantee you any money.
- If you need the money for living expenses, then a lump sum payment might not be right for you. A large portion of your payout will go to taxes and penalties if it’s used to pay bills or buy food instead of investing because withdrawals from retirement accounts are taxed at ordinary income tax rates.
- If the market crashes, then you could end up with less than what you started out with after investing your lump sum payment because it’s possible that some of your initial investment is lost, causing an overall loss on investment.
The Bottom Line
When deciding between taking a lump sum payment or an annuity, it all comes down to your personal needs and goals, as well as how much risk you’re willing to take on.
An annuity is a much safer option because it guarantees you money for life, but if you’d rather have complete control over your investments and don’t mind taking on risk, get the lump sum payment instead.
Many factors go into deciding whether to take an annuity or lump sum payment when receiving insurance payouts like these.
It’s best to do your research before making any decisions so you can make the choice that’s right for your financial situation.
The future of annuity payments is up in the air with new laws being proposed. Still, if they continue to be around, there are many reasons why an annuity might better suit certain situations than a lump sum payment.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.