So you just won the lottery. According to the Texas Lottery, the Lotto Texas® jackpot for Saturday, May 9th is $5,500,000. Imagine what you could do with over $5 million!

A new house? How about a new sports car? A boat? (We discussed that last week!) You’re rich, right? Maybe.

First you better read the fine print. The $5,500,000 is the “Annuitized Jackpot”, or the sum total of payments over 30 years if you elect the payout in the form of an annuity. The lump sum is ONLY $3,820,000.

Misleading as the marketing may be, that’s no paltry sum. It also provides insight into my first rule of managing a windfall.

Rule # 1 – Count it. It may sound simple, but before you start spending a windfall you need to know how much you have. In the lottery example, $5.5 million actually is $3.8 million BEFORE taxes. Assuming you live in Texas and don’t pay state income tax, you would then give up to 39.6% or so to Uncle Sam, so you’d be left with around $2,307,280. That’s still better than chopped liver, but the $400,000 that a new Lamborghini Aventador cost would take a pretty big bite out of the remainder.

Legal settlements can have similar shrinkage once you factor in 30-40% going to attorneys, possible loans and finance charges, and taxes if any of the damages are punitive or for other non-injury cases.

Even inheritances can be subject to up to 40% Federal Estate Tax or US Income Tax in some circumstances.

Once you know how much you have to work with, you can move on to the next rule.

Rule # 2 – Payoff “The Man”. You’ll probably have no shortage of folks approaching you with “opportunities” to invest or spend your newfound wealth. It’s fine to listen, but the only truly guaranteed returns that are absolutely risk free and tax free are to pay off your debts. Let’s say you have a $250,000 mortgage with 20 years left at 4%. Paying that off today would save you $113,588 in interest over the life of the loan.

What you were paying each month can then be thought of as extra income that can be applied to other saving or spending goals. In the above example, that would be somewhere around $18,000 a year in payments you no longer would be making.

In addition, paying off debt should lead to less stress and other psychological benefits, such as not feeling like an indentured servant of the bank or other lender.

Rule # 3 – Endow yourself. When you hear about a school or hospital receiving a huge gift, typically the money is invested in an endowment to produce income that the entity then uses for their needs. This can also prove an effective strategy for an individual if they treat their windfall as an endowment and only use the earnings to supplement their lifestyle.

The National Endowment for Financial Education cites research estimating that 70% of people who suddenly receive a large sum of money will exhaust it within a few years. Lack of financial experience and discipline can likely be attributed in many of these failures.

Let’s look at this Saturday’s lottery as an example of how your “endowment” may work. If you play your lucky numbers and all six are selected (a 1 out of 25,827,165 chance), you would have about $2,307,280 after taxes to work with if you elect the lump sum. I modeled a 60% stock and 40% bond portfolio (fairly typical for an endowment asset allocation) in my financial planning software MoneyGuidePro®.

Withdrawing 4% a year ($92,291) adjusted annually for 2.5% inflation projects a successful outcome in 73% of the simulations over 30 year periods. In addition to the income, the best case scenario showed $13,630,703 left in your account at the end of 30 years, worst case is $0 in 18 years.  

A 73% chance of success may not be a slam dunk but versus a 70% chance of failure, it doesn’t sound so bad. Good luck in this week’s Lotto!