Tax Implications of a Structured Settlement
When a plaintiff receives a structured settlement, it’s important to understand how the funds will be taxed. You should also consider your current financial situation and the goals you want to achieve with the money.
Fortunately, a majority of structured settlement payments resulting from personal injury lawsuits are income tax-free under Internal Revenue Code Section 104. This is due to the Periodic Payment Settlement Act of 1982.
Taxes on Settlement Payments
Under a structured settlement estate tax arrangement, periodic payments are either income tax free or deferred. This depends on the types of damages that are represented by the structured settlement.
Generally, a structured settlement is used in cases where the damages are based on physical injuries. These cases can include wrongful death and derivative claims of family members. The IRS has recognized the benefit of using structured settlements in personal injury cases, and it has adopted specific rules to encourage their use.
For example, under the Periodic Payment Settlement Act of 1982 (Public Law 97-473), personal physical injury awards are tax-free. The annuity or Treasury bond that is purchased to fund a structured settlement is also tax-exempt. This means that the annuitant receives a tax-free, reliable source of long-term income.
A structured settlement is a way of settling litigation with a defendant in which the plaintiff will receive periodic payments over an extended period. The funds are disbursed through an insurance company to fund an annuity. These annuities are designed to provide a long-term financial security for the injured party or their family.
Structured settlements are also a popular way of resolving employment related disputes. They can be used to resolve lawsuits for emotional distress, discrimination, wrongful termination and harassment.
The Internal Revenue Code (IRC) allows plaintiffs to avoid paying taxes on settlement proceeds by establishing a Qualified Settlement Fund (QSF). However, a QSF must be created by the court and cannot be financed by the defendant or anyone else.
Another tax-saving strategy is to pay out a larger percentage of the settlement in general release language, rather than by allocating proceeds among claims and damages. This approach reduces the liability of the defendant, but it can exacerbate the risk of a potential tax audit if allocations are not properly crafted.
Finally, a third tax-saving strategy involves consideration of possible co-claimants. This is a good idea in cases where a spouse, child or other close relative might be able to succeed on a claim for emotional distress or loss of consortium. It also may reduce both the taxability of the plaintiff and the defendant’s liability for estate taxes, depending on the circumstances.
Taxes on Annuity Payments
A structured settlement can be an excellent option for plaintiffs who are struggling financially, and can provide them with the security of guaranteed payments. However, it is important to understand the tax implications of a structured settlement.
Structured settlements are generally considered to be “tax-free” under US tax law, but some exceptions apply. For instance, the amount of punitive damages awarded in a personal injury lawsuit may be taxed.
Another advantage of a structured settlement is that it can be tailored to meet a claimant’s specific needs, providing an additional layer of financial security. Payments may be arranged as periodic, fixed or lifetime, and can be designed to cover future demands such as medical costs or to help them maintain their eligibility for Social Security benefits.
Alternatively, an injured claimant may choose to receive a lump sum from their settlement in order to invest it in stocks or other investments that offer higher returns. This could result in a larger tax liability.
One way to avoid taxes on the funds in a structured settlement is to transfer them into a life insurance policy, which will offer a death benefit. Moreover, it can be transferred into a qualified structured settlement annuity.
As with a life insurance policy, a beneficiary can be named to receive the annuity payments at a future date, or on the owner’s death. The owner can also choose to assign a second beneficiary as a contingency, in case the first is not suitable.
While the principal of annuity funds is typically considered to be tax-free, interest and dividends are often taxable. This can make annuity funds more difficult to manage for some claimants, as they are subject to the same income tax rules that apply to other types of investment accounts.
As with any investment, it is always a good idea to consult with a lawyer and accountant to determine whether annuity payments are the best choice for you. In addition, you may want to consider the possibility of selling your annuity payments if they are no longer necessary for you. This is a process known as factoring. This is regulated under IRC 5891 and requires approval by the court.
Taxes on Lump Sum Payments
A structured settlement can help ensure long-term financial security for injured people. It distributes the money in monthly payments rather than in one lump sum, which could be misspent. This helps injured people pay their living expenses without the need for public assistance.
Most structured settlements are free from US federal income taxes under the Periodic Payment Settlement Act of 1982, which is incorporated into the Internal Revenue Code. This law provides tax benefits for settlements that are used to pay damages for personal physical injuries and wrongful death.
The IRS and state governments are also prohibited from taxing most structured settlement income — whether the payouts are in installments or as a single lump sum payment. This is because the government views structured settlements as restorative, repairing wrongs instead of earning income.
Similarly, proceeds from workplace damages awarded to workers who suffer an injury or disease are not subject to income taxes. These funds are paid to offset lost wages and medical bills incurred due to the worker’s injury.
However, if the worker receives a large lump sum payment and invests it in stocks or other investments, that income may be subject to tax. It is possible to use a so-called factoring transaction to sell these annuity payments to another party, but the sale must follow specific rules, including obtaining court approval.
In addition, some annuity payments are subject to a 40 percent excise tax when sold as a factoring transaction. Exceptions to this rule exist, but it is always best to consult a qualified tax professional before selling any annuity payments.
While most structured settlements are not taxable, some do, especially when the annuity payments are sold in exchange for a lump sum. Regardless, the sale of a structured settlement is a good way to get out of debt or to fund a college education, new business, or a major medical expense.
The sale of a structured settlement is usually not taxable as income, except in cases where the payments are sold as part of a so-called 1035 exchange. The commutation riders arranged at the time of the settlement allow for the conversion of guaranteed future payments, providing funds to pay applicable estate taxes.
Taxes on Inheritance
Inherited assets can be taxable both at the federal and state levels, depending on how they are spent. These include interest on a mortgage, dividends from stocks, and the sale of inherited property or investments.
Inheritance tax is imposed by most states on the amount of an inheritance over a set threshold. Typically, the tax rate is a sliding scale between 5% and 15% based on how much the inheritance exceeds the threshold.
It’s important to note that inheritance taxes are paid by the deceased person’s estate, rather than by heirs directly. That means if you receive an inheritance that is subject to inheritance tax, you will need to file a return and pay the tax within nine months after you receive it.
Luckily, inheritance taxes are generally small. In fact, they can be completely avoided in some cases.
Some heirs, especially spouses, are exempt from inheritance taxes, as are immediate family members like children and grandchildren. In addition, inheritance tax is usually applied only to assets that were owned by the decedent at the time of their death.
Another type of inheritance tax is capital gains tax, which applies to the profits that are earned when heirs sell their inherited assets. This is less harsh than income tax, and it’s based on the value of the inherited asset when it was originally purchased.
The good news is that many heirs who inherit appreciated assets can take advantage of this benefit by selling them while they’re still alive and minimizing the taxable gain.
One way that heirs can protect themselves from an inheritance tax is by setting up a trust. Often, a trust is the best way to ensure that an inheritance remains free of taxes upon death, since it removes assets from the estate and makes them eligible for transfer tax exemptions.
If you own a structured settlement and want to pass it on to your beneficiaries, it’s a good idea to consult with a lawyer about how you can avoid an inheritance tax. This may include using a commutation rider in the structure of the settlement.
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