Lottery SMA’s offer a unique combination of annual payments, and a higher yield. It’s important to note lottery payments come from nongovernmental organizations set up to administer lottery funds. They are NOT general obligations of the state where the lottery is issued, and are fully backed by Treasury bills to offset the amounts due. From a security and credit standpoint, they are like discounted TBills and thus very high credit quality.
How It Works:
Lottery payment streams originate when people select an annuity payout from their lottery winnings as opposed to the lump sum. This selection is usually made when the lottery ticket is purchased.
Let’s presume someone won $1 million. They elected an annuity payout over 20 years, and at interest rates available today, this is a little over $60,000 per year in 20 annual payments.
The lottery commission uses the $1 million it collected from ticket sales, and invests it in zero coupon Treasuries that mature every year for the next 20 years. When the Treasuries mature, they take the proceeds from the zero coupon bond and pay it to the lottery winner.
The yield on this sort of security is very low, approximately 2%. Thus, the winners discount rate, or effective rate of return, is only about 2%. They effectively delegate their $1 million prize to the Lottery Commission who invests in Treasuries.
Now let’s presume the winner decided to sell the future payments for cash today. They decide sell $50,000 per year for 20 years. At a 6% discount rate, they would receive just under $600,000.
You may decide to buy this payment stream at a 5% discount rate. You would pay approximately $625,000. In exchange, you would receive a total of $1M, in 20 equal annual installments of $50,000. The seller would also receive that portion of his or her payment that they decided not to sell.
Just like with regular Structured Settlement Annuities, the case goes to a court with jurisdiction that allows the seller to sell its payments, and gives you an unequivocal legal right to the payment stream.
Lottery Deal and Taxes:
Regular Structured Settlement Annuities are generally not taxable to the original annuitant, and withholdings are not made. This is discussed here. But lottery winnings are fully taxable to the winner, and taxes are withheld by the lottery commission for estimated State and Federal taxes. As the original winner has no basis (Invested capital) in the payments, the withholding is based on full amount of the payment.
As a buyer, however, you DO have an investment basis in the income stream. Just as with other annuities, you use an exclusion ratio to determine the amount of taxable income vs return of principal in each payment.
You will need to file a federal and state tax return in the state where the lottery originated to get a refund of excess withholding.
Lottery Deals, Summary:
It’s important to note that lottery obligations are not a general obligation of the state in which the lottery is issued. Rather, lottery proceeds are used to purchase Treasury securities or other extremely safe assets. Purchasing lottery payments is just like buying Treasury bills at a discount rate.