What Is a Lump-Sum Payment?
A lump-sum payment is a monetary sum paid in one single payment instead of allocated into installments. They are commonly associated with pension plans and other retirement vehicles, such as 401(k) accounts, where retirees accept a smaller upfront lump-sum payment rather than a larger payment issued in installments over time.
In mortgage lending, a "bullet repayment" is the lump-sum of the outstanding loan paid to a lender.
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.
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 payments and one’s financial goals. The company providing the pension will calculate the commuted value of the pension to ensure they can meet their obligations.
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 with annuities. 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.
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.
Lump-Sum vs. Annuity Payments
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 $539,900 in 2022 and $578,125 in 2023, or $647,850 for married couples filing jointly in 2022 and $693,750 in 2023.
Such tax questions depend on the size of the lottery win, current income tax rates, projected income tax rates, state of residency when you win, in which state you will live after the 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 given a 30-year annuity.
FAQs
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 would be the lump sum payment? ›
Lump sum payment refers to a one-time large payment of money given to an employee, usually instead of a series of payments made over time. Lump sum payment has a lower value when provided to pay for an asset or service because the sum total of the funds is being paid upfront.
How do you explain 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).
What is a lump sum of money? ›
What is Lumpsum. Definition: A lump sum amount is defined as a single complete sum of money. A lump sum investment is of the entire amount at one go. For example, if an investor is willing to invest the entire amount available with him in a mutual fund, it will refer to as lump sum mutual fund investment.
What is an example of 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.
What is the lump sum payment structure? ›
Two parties enter an agreement with a set fee. The owner of the contract agrees to pay the contractor the agreed-upon price. The 'lump sum' refers to this total price, not the payment schedule – owners will usually pay in regular installments.
How is lump sum calculated? ›
You must use the mathematical formula: FV = PV(1+r)^n FV = Future Value PV = Present Value r = Rate of interest n = Number of years For example, you have invested a lump sum amount of Rs 1,00,000 in a mutual fund scheme for 20 years.
What is cash lump sum payment? ›
A lump sum is a payment that's made all at once, usually involving a large amount of cash. It's different to instalments, where you receive or pay out smaller chunks of money over time. As you go through life, there are plenty of moments when you might receive lump sums.
What is an example sentence for lump sum payment? ›
Fees were paid for particular services, and lump sum payments were made for surgical operations. Older staff facing structural and technological change in the workplace could bow out ' gracefully ', cushioned by lump sum payments and secure pensions.
What is a lump sum method? ›
Lump sum payment is a single payment of money i.e., one-time payment, as opposed to installations or series of payments. It is most commonly used in the context of pensions, when one has the option of receiving a lump-sum pay-out from your pension provider or smaller payments over time, or a combination of both.
Bottom Line. Deciding between taking a lump sum or regular monthly payments requires evaluating your expected life span as well as how soon you can receive the lump sum. A longer life expectancy tends to favor monthly payments, while the sooner you can get the lump sum, the better that option looks.
What is the description of lump sum? ›
Definition. A lump sum is a single payment made at a particular time, as opposed to a periodic instalment.
How do lump sum payments work? ›
A lump sum payment is single payment of a sum of money. Lump sums are generally used for retirement plans, inheritances and even lottery payouts. For instance, if you've got an IRA, you may choose to abandon a monthly payment to receive the full earnings from the retirement account.
What is the smartest thing to do with a lump sum of money? ›
Start paying off the debt with the highest interest rates and work your way down to the debt with the lower rates. If you cannot pay all your high-interest debt with your windfall, pay as much as possible and focus your attention on other high-interest debt.
Do lump sums get taxed more? ›
The Internal Revenue Service (IRS) classifies pension distributions as ordinary income. This means they're taxed at the highest income tax rates. The agency says that mandatory income tax withholding of 20% applies to the majority of lump sum distributions from employer retirement plans.
How to avoid taxes on lump sum payout? ›
You may be able to defer tax on all or part of a lump-sum distribution by requesting the payer to directly roll over the taxable portion into an individual retirement arrangement (IRA) or to an eligible retirement plan.
