Structured settlements pay out over time as a stream of tax-free payments, rather than as one lump sum. You can “cash in” your future structured settlement payments by selling them to a factoring company at a discount if you need immediate cash. Most structured settlements stem from personal injury, wrongful death or workers’ compensation lawsuits. Structured settlements are agreed upon between a lawsuit’s injured party and the defendant.
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Key Takeaways:
- Structured settlements are a stream of tax-free payments issued to an injured victim. The settlement payments are intended to pay for damages or injuries, providing financial security over time.
- Structured settlement payments are guaranteed by the insurance company that issued the annuity. They do not fluctuate with market changes like stocks, bonds and mutual funds.
- There are more pros than cons for choosing to receive a structured settlement over a lump sum. Spreading out payments over time can reduce temptation, but once the terms of a structured settlement are finalized, there’s little you can do to renegotiate.
What Is a Structured Settlement?
Structured settlements are simple. Many civil lawsuits result in someone or some company paying money to another to right a wrong. Those responsible for the wrong may agree to the settlement on their own, or they may be forced to pay the money when they lose the case in court.
If the amount of money is small enough, the wronged party may have the option to receive a lump sum settlement. For larger sums, however, a structured settlement annuity may be arranged.
In this case, the at-fault party puts the money toward an annuity, which is a financial product that guarantees regular payments over time from an insurance company.
The agreement details the series of payments the person who was wronged will receive as compensation for the harm done to them. Spreading the money over a longer period of time offers a better future guarantee of financial security because a single payout can be spent quickly.
History of Structured Settlements in the U.S.
The U.S. has a rich history of structured settlements, but that wasn’t always true. Modern adoption of these payments can be traced back to Canada in the 1960s when a medication called thalidomide caused birth defects in thousands of children. Rather than receive a one-time payment from the at-fault pharmaceutical company, the claimants needed a series of payments over a longer timespan to cover future medical bills.
Structured settlements were first issued in the U.S. in the 1970s when similar cases arose. In that decade, the IRS Revenue Ruling 79-220 that was issued in 1979 provided tax benefits for the recipient, citing, “The taxpayer’s only right with respect to the amount invested was to receive the monthly payments, and the ruling concluded that the taxpayer did not have actual or constructive receipt or economic benefit of the amount invested.”
Settlement payments to the injured party did not count towards their gross income, and thus they were not required to pay taxes on any money received. Likewise, after the recipient passed away, payments to the estate continue to be excluded from taxation.
Structured settlements gained popularity in the 1980s after the U.S. Congress passed the Periodic Payment Settlement Act of 1982. The act served as the federal government’s buy-in with the IRS ruling and extended restrictions to the state governments, barring them from taxing structured settlement income from personal injury cases.
By 1985, the National Structured Settlements Trade Association formed to preserve and promote structured settlements to injury claimants through education and advocacy.
Over a decade later, the Small Business Job Protection Act of 1996 set limitations on the types of personal damage cases eligible to receive the tax benefits. As a result of this act, only damages from “personal physical injuries or physical sickness” can exclude payments from gross income. Payments from punitive damages were no longer eligible for tax exclusions.
Today, structured settlements remain a trusted source of financial security, with an estimated $10 billion annual payments issued to over 30,000 recipients. Now, it’s become commonplace for the claimants to choose a preference for periodic payments, a one-time lump-sum payout, or a blend of both.
How Do Structured Settlements Work?
Legal settlements can be paid out in a one-time lump sum or through a structured settlement where periodic payments are made through a financial product known as an annuity. The key differences between these settlement options are in the areas of long-term financial security and taxes.
When a plaintiff receives a settlement through a one-time lump sum, they might spend it too quickly, robbing them of the long-term financial security that future payments could provide.
Moreover, any interest and dividends earned if the lump-sum were to be invested would be subject to taxes. Conversely, an annuity is meant to provide income throughout the recipient’s lifetime, and any interest and taxes earned through the annuity will grow tax-free.
Types of Structured Settlement Cases
There are a number of reasons why an individual may receive a structured settlement. The most common cases include:
Payout Options for Structured Settlements
If you elect to receive your lawsuit payout through a structured settlement, you can determine whether to begin to receive the funds immediately or at a later date. Immediate payments can be beneficial if you require medical care, for example, or have lost your source of income. You may decide to postpone the payments until a later time, such as after you retire. During the waiting period, the annuity will grow as it earns interest.
You can also determine whether the annuity should be paid for the rest of your life, no matter how long that may be, or for a specified number of years, as well as the schedule for receiving payments and the payment amounts and adjustments.
Often, plaintiffs will need money for a variety of expenses before they receive their settlement. If you find your expenses mounting as you await your first structured settlement payment or initial lump sum, you may want to consider pre-settlement funding options to tide you over.
That’s all.