All About Converting Annuity Payments to a Lump Sum

And Vice Versa

Insurance settlements and lottery payouts can be taken as either annuities or lump sums. An annuity is an agreement wherein the payee receives a fixed amount every year for a certain number of years. Put another way, an annuity is a payment plan in which a large sum of money is distributed in smaller increments over a period of several years. When a person wins the lottery, or a victim wins a huge settlement from the insurance company, he has a choice between taking the money in a single large amount, or receiving payments on a yearly basis.

As it turns out, the sum of the yearly annuity payments is larger than the lump sum value. Thus, there is a trade off between getting your money all at once, or taking it in smaller increments. If you want to convert an annuity value to a lump sum, or a lump sum to an annuity, you can calculate the conversions with the formulas below.

You can also use our online structured settlement calculator. You will need to know the annual interest rate of the annuity as well as the number of years. Just click the radio button that corresponds to the conversion you want to make. The red entries are for converting a lump sum to an annuity, and the blue entries are for converting an annuity to a lump sum.

Lump Sum to Annuity

You will need to know the values of three variables for this calculation: the amount of the lump sum L, the number of years N, and the annual interest rate R expressed as a decimal.

The yearly annuity payments A are then given by the equation

A = [ LR(1+R)^N ]/[ (1+R)^N - 1 ].

For example, suppose a lump sum is valued at $1,000,000. If it is taken as an annuity for 40 years at an annual rate of 3%, then L = 1000000, N = 40, and R = 0.03. The value of A is

[ (1000000)(0.03)(1.03)⁴⁰ ]/[ (1.03)⁴⁰ - 1 ]
= (30000)(3.26204)/(2.26204)
= 43262.

Thus, the yearly payments are $43,262.

Annuity to Lump Sum

For this conversion, you must know the annuity value A, the number of years N, and the annual interest rate R expressed as a decimal.

The equivalent lump sum payment L is given by the formula

L = A[ (1+R)^N - 1 ]/[ R(1+R)^N ].

For instance, suppose you will receive $40,000 each year for the next 23 years. If the interest rate is 3.5% annually, then A = 40000, N = 23, and R = 0.035. The lump sum equivalent L is

(40000)[ (1.035)²³ - 1 ]/[ (0.035)(1.035)²³ ]
= (40000)(1.20611)/(0.077214)
= 624814.

In this case, the annuities can be consolidated into one immediate payment of $624,814.

Should I Choose a One-Time Cash Settlement, or an Annuity?

The answer to this question depends on many factors, including your current financial situation, your debts, your tax burden, the interest rate, the size of the settlement or jackpot, and whether you must share the money with others. When the applied interest rate is high, annuities are a good option, especially if the interest rate is higher than the rate of return on your other savings and investments.

If you have many debts to pay off, or the settlement is small, it may be better to take the money in one large payment, rather than wait for small payments every year. The elderly may also have reasons to take a one-time payment.

Ultimately, it comes down to personal preference and how much tax you will owe. You should talk to an accountant or tax attorney to see how much the IRS will take.

© Had2Know 2010