What Is a Lump-Sum Payment?
A lump-sum payment is a monetary sum paid in one single payment instead of allocated into installments. Lump sums are commonly associated with pension plans and other retirement vehicles, such as 401(k) accounts, where retirees might accept a smaller upfront lump-sum payment rather than a larger payment issued in installments over time.
Key Takeaways
- A lump-sum payment is an amount paid all at once, as opposed to an amount that is paid in installments.
- A lump-sum payment is not the best choice for everyone. For some, it may make more sense for the funds to be annuitized as periodic payments.
- Based on interest rates, tax situation, and penalties, an annuity may end up having a higher net present value (NPV) than the lump-sum.
Understanding a Lump-Sum Payment
Lump-sum payments can describe a bulk payment to acquire a group of items, such as a company paying one sum for the inventory of another business. Lottery winners will also typically have the option to take a lump-sum payout versus yearly payments.
Annuities provide a degree of financial security, but an older retiree in poor health might derive greater benefit from a lump-sum payment. Securing an upfront payment often guarantees an asset to pass on to your heirs.
An upfront payment might enable you to buy a house or other large purchase that you would otherwise not be able to afford. Similarly, you can invest the money and potentially earn a higher rate of return than the effective rate of return associated with the annual payments.
The company providing the pension will calculate the commuted value of the pension to ensure they can meet their obligations.
Lump-Sum vs. Annuity Payments: An Example
To illustrate how lump-sum and annuity payments work, imagine you win $10 million in the lottery. If you take the lump-sum payment, the entire winnings would be subject to income tax in that year, and you would be in the highest tax bracket.
However, if you choose the annuity option, the payments could come to you over several decades. For example, instead of $10 million in income in one year, your annuity payment might be $300,000 a year.
You would avoid the highest federal income tax bracket of 37% for single people with incomes greater than $609,350 in 2024 ($578,125 in 2023), or $731,200 for married couples filing jointly in 2024 ($693,750 in 2023).
Such tax questions depend on the size of the lottery win, current income tax rates, projected income tax rates, your state of residency when you win, in which state you will live after your win, and investment returns. But if you can earn an annual return of more than 3% to 4%, the lump-sum option usually makes more sense compared to a 30-year annuity.
Which Is Better, a Lump Sum or an Annuity?
There are pros and cons to accepting a lump-sum payment rather than an annuity (fixed payments over a period of time). The right choice depends on the value of the lump sum versus the periodic payments and one’s financial goals.
It is not always best to take the lump-sum payment in lieu of periodic annual payments; if offered the choice, consider taxes, investments, and the net present value (NPV), which accounts for the time value of money.
Is a Lump Sum Risky?
Receiving a lump sum payment is not necessarily risky. However, if you receive it as physical cash, security may be an issue. It may also be risky to deposit the lump sum in one investment option (such as a single stock), rather than diversifying your investment. Diversification reduces risk.
Why Is It Called Lump Sum?
A "lump," according to Merriam-Webster, is an adjective that means "not divided into parts", or "entire." A "sum," according to the dictionary, is "an indefinite or specified amount of money" or "the whole amount," or "aggregate." As a term, "lump sum" means "an amount of money that is paid at one time" or "a single sum of money."
The Bottom Line
A lump-sum payment might be an option in multiple situations. In mortgage lending, a "bullet repayment" is the lump-sum of the outstanding loan paid to a lender. More commonly, you may have a lump-sum option with a pension.
A lump-sum comes with pros and cons. One advantage is that with a lump sum, you have more control up front, and once you receive it, you can invest the money however you wish. However, you may receive less money in a lump sum than you would have if you took periodic payments. Taxes are also a concern.
This is a situation where it's a good idea to choose carefully. If you have any questions, consider reaching out to a financial advisor.
FAQs
Increasingly, employers are making available to their employees a one-time payment for all or a portion of their pension. This is known as a lump-sum payout option. If you choose a lump-sum payout instead of monthly payments, the responsibility for managing the money shifts from your employer to you.
How do lump sum payments work? ›
A lump-sum distribution is an amount of money due that is paid all at once, as opposed to being paid in regular installments. Lump-sum distributions may be made from retirement plans, commissions earned, windfall earnings, or certain fixed-income investments.
What is the meaning of lumpsum payment? ›
A lump sum payment is an amount of money that is paid in one single payment rather than in installments. Life insurance policies provide either a lump sum payment or a set annual amount for a fixed period.
How do you explain lump sum? ›
A lump sum is an amount of money that is paid as a large amount on a single occasion rather than as smaller amounts on several separate occasions. Drag the correct answer into the box.
What are the pros and cons of a lump sum? ›
A lump-sum comes with pros and cons. One advantage is that with a lump sum, you have more control up front, and once you receive it, you can invest the money however you wish. However, you may receive less money in a lump sum than you would have if you took periodic payments. Taxes are also a concern.
What qualifies as a lump sum payment? ›
a lump-sum payment made in place of several periodic payments that were required by a court order or written agreement, but were not yet due to be paid (a prepayment). However, the prepayment may be considered a support payment if it was made for the sole purpose of securing funds to the recipient.
What does the IRS consider a lump sum payment? ›
What Is a Qualified Lump-Sum Distribution? It is the distribution or payment in 1 tax year of a plan participant's entire balance from all of an employer's qualified plans of one kind (for example, pension, profit-sharing, or stock bonus plans) in which the participant had funds.
Is it good to pay lump sum? ›
Benefits of Lump Sum Payments
Shorter amortization: Not only does this extra payment reduce your interest, but it also speeds up your path to becoming mortgage-free. Because each payment goes directly to your principal, your overall amortization is reduced.
Why lump sum is better than payments? ›
Pension payments are made for the rest of a retiree's life. Lump-sum distributions allow individuals to spend or invest the money. People who take a lump sum may outlive their money, while traditional pension payments continue until death.
Can I withdraw a lump sum anytime? ›
The most common question is whether one can withdraw mutual funds at any time. The answer is yes; however, there are certain things to keep in mind while withdrawing your mutual funds.
When you make a lump-sum payment on your mortgage, your lender usually applies it to your principal. In other words, your mortgage balance will go down, but your payment amount and due dates won't change.
What is the best thing to do with a lump sum of money? ›
What to do with a lump sum (during a cost-of-living squeeze)
- Pay off debt. A central foundation of a healthy financial position is keeping debt under control. ...
- Save up an emergency fund. ...
- Lump sum investments. ...
- Deposit a lump sum into your pension.
How do you calculate total lumpsum? To calculate a total lumpsum, you sum the initial investment with any earnings or interest gained over the investment period. This requires knowledge of the initial amount, interest rate, and investment duration.
What is an example of a lump sum payment? ›
A lump sum is a one-time payment to an employee. Examples are bonuses, commissions, severance, and vacation payouts.
Is a lump sum risky? ›
Lump sum investments offer the chance for higher returns but come with risk. They're ideal for long-term investors comfortable with market swings and who have a windfall to invest. Otherwise, SIPs might be a better fit.
How much money is considered a lump sum? ›
A lump sum is a single payment of money, as opposed to a series of payments made over time (such as an annuity).
Do lump sum payments get taxed? ›
Lump-sum taxes
As a result, when you make withdrawals, you'll typically owe taxes on both your original pre-tax contributions and any income or profits you generated. Lump-sum distributions can kick you up into a higher tax bracket.
Is it better to take a lump sum or monthly payments? ›
A monthly pension payment gives you a fixed amount every month over your whole life, so you don't have to worry about changes in the stock market. In contrast, a lump-sum payout can give you the flexibility of choosing where to invest or save your money, and when and how much to withdraw.
How are lump sum contracts paid? ›
Let's consider a municipal government that is planning to build new roads. With a lump sum contract, the government agrees to pay a fixed price for the entire project. This approach ensures budget certainty because the total cost is known from the start. It's ideal for projects with well-defined scopes.
