A structured settlement is a financial settlement paid out as an annuity rather than in a lump sum. It is often the result of a legal or insurance claim. In 1982 Congress created special tax rules to encourage the use of structured settlements to provide long-term financial security to seriously injured victims and their families. This can be beneficial not only for tax purposes but also for those who would have difficulty managing large sums of money that will be needed to provide for the rest of their life.
Typically, the structured settlement is the result of a lawsuit where the injured party (the claimant) settles with the defendant (or its insurance carrier). In exchange for the dismissal of the lawsuit the defendant agrees to make a series of periodic payments over time. This can be handled by the defendant purchasing a lifetime annuity from an insurance company with the claimant as the beneficiary. So at that point the successful claimant is now the owner of an annuity (i.e. a series of fixed payments for the rest of their life or possibly for a certain fixed period of time.)
What You Should Know Before Accepting Cash for Structured Settlement Payments
Annuities guarantee income for life – who wouldn’t love that? But what if you need cash right now. What do you do? One option is to sell your structured settlement for cash up front. Another option is to borrow against your structured settlement. Think long and hard before selling a structured settlement.
Your Payments Are Tax-Free
Before accepting cash for structured settlement payments, keep one very important thing in mind: your payments are probably entirely tax free right now. If you’ve received money as a result of a personal injury suit, you’re not paying tax on that money. When you trade in that settlement, you might end up owing state and federal tax on the amount you receive – ouch.
Don’t discount the amazing nature of tax-free payments. There aren’t many sources of tax-free income these days. But let’s suppose you’re receiving money from an annuity that’s not part of a personal injury lawsuit. Unless that annuity is inside of an IRA, you’re only paying a small amount of tax on the payments.
Annuities are tax-favored financial products. Most of the money you’re receiving is a return of principal. Only a small percentage of it is interest. This is called the “exclusion ratio.” Only the interest you receive is taxed. So, roughly 90 to 95 percent of your payment (possibly more) is untaxed. It might be a good idea to keep it that way. After all cashing in your structured settlement is like chopping down an apple tree for firewood or killing the goose that lays the golden eggs.
You Only Get a Fraction of Your Total Settlement When You Sell
When you sell annuity payments, companies always discount your annuity to represent its current value. When you’re getting payments over time, these payments are representative of principal and interest.
A settlement funding company will discount your future payments to today’s dollars. That means you only get a small fraction of your total settlement. For example, if you estimate you have $100,000 in total payments left on your annuity, you may only get $20,000 or less as a lump sum. That’s because the funding company calculates a discount rate – a rate that, when that $20,000 is invested – will total $100,000 over the life of the annuity.
But even before you receive your discounted lump sum amount, the funding company subtracts fees for its services.
Your Payments Are Guaranteed
With an annuity, your payments are guaranteed according to the terms of the contract. If you have a lifetime annuity, payments are guaranteed for life. If you have a period certain annuity, your annuity payments are guaranteed for a set number of years.
You will be giving up rights to all future payments if you cash in all of your annuity. Even if you cash in part of your annuity, you might be seriously diminishing the future payments.
The lump sum of money you receive isn’t going to be guaranteed unless you invest in a guaranteed investment like a fixed bond, bank CD, or another insurance policy. In most cases, trading in your annuity is a bad idea simply because of the fact that the insurer spreads out the financial risk of you losing that money. When you take a lump sum payout, you concentrate your risk of loss. So in addition to the fees and the risk of spending it all at once, you will pay higher taxes and possibly some penalties. So definitely think carefully before cashing in a structured settlement.
 See Also:
- Must Know Information About Annuities
- Life Insurance and Annuities: The Secret is the Bottom Line
- The Truth About Annuities
- How to Choose a Financial Advisor
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