A large, lump-sum settlement of a legal claim can seem like manna from heaven. You can take care of unpaid medical bills, make up for lost wages due to missed work-time, or even pay for a vacation to relieve some of the stress from the lawsuit.
But big lump-sum payments also raise some potential problems.
You see, if the settlement is taxable, the payment might markedly increase your marginal tax rate so that you lose a sizeable chunk of the money to the government.
Or it might jeopardize your eligibility for Medicaid or SSI benefits.
And, when you have a large pile of cash on hand, it’s tempting to spend it right away, even though you might need that money for medical treatment in the future.
The potential pitfalls of lump-sum settlements led to the advent of what are known as “structured settlements.”
Structured Settlement Defined
In a nutshell, a settlement is “structured” if it involves multiple payments over time rather than one big lump sum.
A structured settlement can reduce total tax liability, and, more importantly, ensure that the recipient has a steady income stream over an extended time.
A steady income stream over time can be particularly important for plaintiffs in tort cases whose injuries have affected their ability to earn a living. The income may be used to replace previous earnings that the plaintiff is no longer able to make.
Of course, structured settlements raise new problems of their own. Most defendants – or more typically their insurance companies – don’t want a financial liability hanging over their heads for a decade or more.
Rather, defendants and insurance companies prefer to resolve the matter and retire the file.
And plaintiffs want some assurance that all of the structured payments will be made as agreed.
If a defendant becomes insolvent halfway through a payment plan, it could be very difficult, or even impossible, to recover the rest of the money. There’s no risk of default on payment obligations if you receive the entire settlement up front.
Structured settlement annuities are designed to offer the benefits of a structured settlement while reducing or eliminating the potential drawbacks. When used properly, they can be a very effective tool for protecting a settling plaintiff’s long-term financial security.
What are Structured Settlement Annuities?
Our definition of structured settlement annuities would be a financial product purchased for a plaintiff by a defendant (or a defendant’s insurance company) as part of a legal settlement.
Under the terms of a settlement agreement, the defendant buys an annuity from a life insurance company (or similar institution), which in turn makes annuity payments to the plaintiff over an extended time.
After funding the annuity, the defendant is released of any further liability and can wash its hands of the matter.
As the annuity’s beneficiary, the plaintiff gets prolonged, tax-advantaged payments with virtually no risk of default.
In the rare event that an insurance company issuing an annuity becomes insolvent, the annuity’s value is protected by the applicable state guaranty association.
And the annuity earns interest, resulting in total payments that ultimately exceed what would have been received had the settlement been tendered as a lump sum.
3 Parts to Structured Settlement Annuity
There are basically three parties to a structured settlement annuity – a person asserting a legal claim, the person or entity against whom the claim is asserted (or their liability insurance carrier), and a “qualified assignee.”
The qualified assignee is the life insurance company or similar financial institution that sells the annuity contract to the defendant and then makes the annuity payments to the plaintiff.
The “qualified” part is important because the tax code permits qualified assignees to exclude premium payments received for qualifying structured settlement annuities from their taxable income. This premium payment exclusion in the tax code enables the qualified assignee to provide greater overall payments to the plaintiff while still earning a profit on the transaction.
How Do Structured Settlement Annuities Work?
Structured settlement annuities start with a plaintiff who has a high-dollar personal injury, workers compensation, medical malpractice, wrongful death or similar liability claim or judgment.
To resolve the claim, the defendant purchases an annuity from the qualified assignee, and the parties work out how the annuity will be paid as part of the settlement. They decide on the amount of the individual payments, how long the payments will extend, how frequently payments will be made, and whether payments will be in a fixed or varying amount.
The appropriate payment terms can vary considerably depending upon the plaintiff’s situation, subject to some limitations on qualifying annuities set forth in the tax code.
A plaintiff with substantial unpaid medical bills or attorney’s fees might want to receive a large percentage of the total settlement up front to pay off debt and then annuitize the remainder.
A minor plaintiff (structured settlement annuities are popular in minor settlements) might receive small payments early on, or even defer payments, and then increase the amounts upon reaching adulthood or to pay for college.
Some plaintiffs prefer to receive the same payment amount every month or every quarter for decades so that the annuity provides consistent income like a pension. Others opt to receive relatively small payments during their working years, allowing the annuity to grow into a larger asset that they can rely on for retirement.
Importantly, most structured settlement annuities have a defined term of years and therefore differ from the lifetime income annuities that are popular in retirement planning. However, structured settlement annuities can be set up to provide lifetime payments.
Once the settlement terms are worked out and the annuity is in place, the qualified assignee makes the payments to the plaintiff according to the agreed terms.
The structured settlement annuity earns guaranteed interest at a pre-set rate so that, in the long run, the total payments exceed the premium paid to the assignee by the defendant. Annuity growth rates are generally comparable to CD’s – not as high as average stock market returns, but better than most savings accounts.
Benefits and Drawbacks of Structured Settlement Annuities
The principle benefit of structured settlement annuities is that they guaranty a steady income stream over a prolonged period. This steady income stream is especially important for claimants who require future medical treatment or whose earning capacity has been diminished by their injuries. By removing the temptation to spend all or most of a settlement on luxuries early on, annuities remove the risk of not having cash available for future bills or living expenses.
On the other hand, settlement funds tied up in an annuity are for the most part inaccessible. If your circumstances change or an unforeseen expense emerges and you need the bulk of the money right away, you can’t cash out except by selling the right to receive future payments.
Transfers of structured settlements are tightly regulated, requiring court approval, and there will be a delay before the cash is available. Selling annuity rights often ends up being a poor financial decision and should generally be avoided unless there is a clear advantage to getting less money sooner rather than more money later.
Like other types of annuities, structured settlement annuities provide for budgeting certainty. Knowing how much and how often you will receive payments helps with everything from retirement planning to selecting a mortgage.
And, critically for Medicaid and SSI recipients, a well-conceived structured settlement annuity, like a special needs trust, can preserve eligibility for benefits that a large lump-sum payment might jeopardize.
Even plaintiffs who have the discipline to save and invest settlement funds run the risk of losing some of the money if an investment doesn’t pan out.
Annuities, though, remove the risk of poor investment performance.
Statistically, long-term investments in reputable mutual funds will probably out-perform an annuity. However, the risk of a market crash or recession resulting in limited growth or lost principal is always present.
Annuities are virtually guaranteed not to lose money, and, unlike stock market gains, the earnings on a qualified annuity are not subject to income tax – partially making up for the decreased potential returns.
The other side of the coin is that settlement annuities, with their fixed interest rates, are vulnerable to inflation.
If the cost of living increases at a faster rate than the annuity, the real value of the payments will be less in the future than if received at the time of settlement.
The time value of money is a legitimate concern, so anyone offered a structured settlement annuity needs to weigh the current value of a lump-sum payment against the long-term certainty and tax advantages provided by an annuity.
It’s usually a good idea to consult with a knowledgeable personal financial adviser before committing one way or the other. Ultimately, the better choice is not always clear and depends upon the claimant’s individual circumstances.
Tax Advantages of Structured Settlement Annuities
Structured settlement annuities became popular beginning after the 1982 passage of the Periodic Payment Settlement Act (PPSA), as Congress added to I.R.C. Section 104 (a)(2) the following emphasized words “whether by suit or agreement and whether as lump sums or as periodic payments.“(1)
The PPSA was a Congressional response to the problem of personal injury plaintiffs burning through large, lump-sum settlements in short order and then requiring public assistance. To incentivize structured settlements, Congress established tax incentives for both the person receiving the settlement and the insurance company issuing the annuity.
As alluded to above, the qualified annuity premium received by the issuing insurance company is not included as taxable income to the company. Without the additional tax expense, the insurer can offer more attractive terms, including higher interest rates and overall payment amounts, while still realizing a profit.
More importantly for settling plaintiffs, the growth earned on an annuity that meets PPSA requirements is not taxed. Personal injury and workers compensation settlements are generally viewed as reimbursement for injuries and therefore not treated as taxable income.
But any growth earned from investing the settlement funds is taxable income . . . unless the growth comes from a qualified structured settlement annuity.
To qualify for tax-free growth, the annuity must be funded from a judgment or settlement of a claim for physical injury or sickness, which can include personal injury, medical malpractice, wrongful death, or workers compensation claims, and the settlement must provide for periodic payments to the claimant.
If you settle a personal injury case for $100,000 and invest the money in the stock market, any earnings will be taxed. However, if that same $100,000 settlement is used to fund a qualified annuity, the growth is tax-free.
Depending on how long the annuity is extended, the tax savings can end up being thousands of dollars. Importantly, though, according to 26 U.S. Code § 130, the tax-advantaged status is lost if the annuity payments are “accelerated, deferred, increased or decreased by the recipient.” (2)
Not all structured settlement annuities are “qualified” under the PPSA, but unqualified annuities funded from settlements of other claims can still offer tax advantages.
For instance, a payment for punitive damages or in settlement of a discrimination claim is taxable income to the payee. Depending upon the amount of the settlement and the plaintiff’s marginal rate, the tax bill could eat away a significant percentage of the money.
However, with a structured settlement annuity, payments are stretched out over multiple tax years so that the recipient stays in a lower tax bracket and, as a result, overall tax liability is decreased.
Likewise, payments can be timed so that larger amounts are received after retirement when the recipient will likely be in a lower tax bracket.
It’s worth noting that unqualified annuities can also be funded from sources other than legal claims. Lottery winners, for example, can use annuities to preserve their winnings long-term, reduce their overall income tax liability, and receive a greater total payment amount than what would be received with a lump sum.
Regulation of Structured Settlements
As structured settlements increased in popularity, lawmakers began noticing a problem. All too often, recipients of structured settlement annuities sold their rights in exchange for lump sum payments under unfavorable – and sometimes just plain unfair – terms.
In response to the emergence of these “factoring agreements,” 48 state legislatures have adopted statutes regulating structured settlements generally and assignment of payment rights in particular.
Structured Settlement Protection Act (“SSPA”)
In 2002, the federal government followed suit, enacting the Structured Settlement Protection Act (“SSPA”).
The SSPA acknowledges the widespread state legislation and leaves the specific regulatory details to the states.
Assignments must comply with applicable state statutes and be approved by a judge in the state in which the assigning individual resides. The order approving the transfer must find the assignment to be “in the best interest of the payee, taking into account the welfare and support of the payee’s dependents.”(3)
If the payee lives in one of the few jurisdictions that have not regulated factoring agreements, the transfer can be approved by a court in the insurance company’s home-state.
Giving the Act some teeth, the SSPA uses the Internal Revenue Code to impose stiff penalties for noncompliance. The penalties come in the form of an excise tax measured as 40% of the difference between the price paid to the annuitant and the undiscounted value of the rights at the time of transfer.
In effect, this means anyone who purchases someone else’s right to receive structured settlement payments without first obtaining the approval of a state-court judge must pay to the IRS forty percent of the eventual profit on the transaction, without any discount for the delayed access to the cash.
State statutes focus on providing information about a potential assignment’s ramifications to the person selling payment rights.
Using Florida’s structured settlement law, codified at Fla. Stat. §626.99296, as an example, the statute requires the purchaser to provide written notice to the payee informing him or her of the amounts and dates of the payments being transferred, the total amount to be paid by the purchaser in exchange, the discounted present value of the payments (i.e., what the right to receive the future payments is worth now), the amounts of all fees and service charges involved in the transaction, and the effective interest rate.
The interest rate is calculated as if the price paid by the purchaser is a loan from the purchaser to the payee and the transferred annuity payments are payments made by the payee to the purchaser in repayment of the loan.
Following a hearing in the court of the county in which the payee resides, the presiding judge must enter an order finding the transfer to be “fair, just, and reasonable” before the assignment of rights can go forward.
This is why…
Anyone considering assigning his or her rights to receive payments under a structured settlement annuity should research the purchasing company’s reputation before proceeding. An experienced financial adviser can help explain the economic consequences of entering into a factoring agreement and provide advice on identifying a reputable purchaser offering the best terms available.
It’s also why…
We would recommend that anyone even considering purchasing an annuity first give us a call here at I&E so that we can provide you with several options for you to consider before you make any kind of “commitments”.
So, what are you waiting for? Give us a call today and see what we can do for you!