An annuity is a financial product issued by insurance companies that guarantees regular payments over time. People often buy annuities before retirement to offset the risk of outliving their savings.
But annuities can also be created after winning a big settlement in a personal injury or wrongful death lawsuit. Instead of funding the annuity yourself, the annuity is funded with money you won in the case.
Structured settlements can be a good option in certain situations, but like all annuities, you’ll give up immediate access to your money in exchange for guaranteed future payments.
Here’s everything you need to know.
What is a structured settlement annuity?
A structured settlement is an agreement where you receive smaller, scheduled payments over time from a legal settlement, instead of one large payment.
These tax-free payments are often part of personal injury or other legal settlements and they reimburse victims for damages or injuries. These arrangements are often voluntary, or in most cases involving minors, court-ordered.
Because many of these plaintiffs have suffered significant injuries, payouts are intended to compensate for years — sometimes decades — of medical bills and other costs. Structured settlements were created to ensure the money someone receives from these cases lasts.
To promote the use of structured settlements, Congress enacted the Periodic Payment Settlement Tax Act of 1982, which gives these arrangements favorable tax treatment.
While they function similarly to a retirement annuity purchased in the private market in some ways, structured settlements are also subject to complex regulations.
How does a structured settlement work?
When a structured settlement is ordered, the at-fault party is required to purchase an annuity or U.S. Treasury obligation using the settlement funds.
The at-fault party often uses what’s called an assignment company to create the annuity. The assignee is usually affiliated with a life insurance company and typically buys the annuity from that insurer.
The insurance company then invests the lump sum into relatively low-risk assets, such as U.S. Treasuries, bonds and mortgage loans. This way, the money can earn interest inside the annuity.
Structured settlement annuities are backed by major insurance companies like MetLife, New York Life and Pacific Life. These companies have strong financial and credit ratings from independent agencies, so the risk of the insurer defaulting is extremely low.
Payout options for structured settlements
Structured settlement payouts are highly customizable. For example, you can decide to start payments right away or delay them until a later date, like retirement.
Payouts don’t necessarily need to be made in equal amounts either. For example, a settlement for a minor could arrange for a larger payout from age 18 to 24 to cover college tuition, then lower payments after that.
Finally, you can decide whether the annuity should pay out for a set number of years or the rest of your life.
Is it better to take a lump sum or a structured settlement?
The decision to opt for a structured settlement is personal. While many types of people can benefit from this arrangement, vulnerable parties — such as minors or people with severe disabilities — may benefit the most. Ultimately, the decision depends on your personal situation, financial goals and your comfort level with managing money.
If you receive your settlement as a single lump sum, it can be tempting to spend it. After all, most people don’t have experience managing a huge influx of cash. That’s why Congress designed structured settlements — to encourage people to spread out payments over time. This way, you’ll have steady income to cover your living expenses and medical costs when you need it.
Structured settlements also offer attractive tax benefits. While the proceeds from a lump sum injury settlement are already tax free, if the proceeds are later invested elsewhere, any interest or dividends earned are taxable.
Imagine that you received a $500,000 personal injury settlement. If you invest half the money in the stock market, you’ll likely be responsible for paying tax on any dividends or interest, as well as capital gains if you sell those investments later for a profit. But with a structured settlement, the money within the annuity grows tax-free and payments won’t be taxed.
However, structured settlements are rigid legal contracts. Once the payout terms are finalized, you’re locked into the agreement, so you won’t be able to access the money whenever you want.
And if you try to sell future payments to free up cash today, you’ll never receive the full value of those payments. That’s why it’s so important to make sure the terms of the structured settlement work for you before finalizing the deal.
In short, if you’re not sure how you’d manage a windfall, a structured settlement can be a smart choice. On the flip side, if you’re confident in your financial planning skills, a lump sum could offer more flexibility and growth potential.
Pros and cons of structured settlements
Pros
- Predictable payouts: Structured settlements offer a stable and predictable stream of income over time, like a paycheck. This can make monthly budgeting easier.
- Protection from market risks: Structured settlements are generally invested in low-risk assets, such as bonds and Treasuries. Regardless of how those investments perform, the insurance company guarantees your future payouts. So the insurer assumes all the market and interest rate risk, not you.
- Customizable: Payouts can be tailored to your specific needs, lasting for a set number of years or the rest of your life.
- Spendthrift protection: A one-time windfall can quickly evaporate. A structured settlement protects against this risk. It also takes the guesswork out of how to manage and invest such a large sum of money.
Cons
- Lack of flexibility: Once the terms are set, it’s nearly impossible to make changes to a structured settlement. And you won’t be able to access future payments ahead of schedule unless you sell those payments at a discount.
- Inflation risks: Fixed payments may lose value over time due to inflation, especially if the settlement doesn’t include cost-of-living adjustments.
- Lower potential investment returns: You might earn a higher return by accepting a lump sum and investing it in assets with higher potential rates of return, such as stocks. But that also means you’ll need plenty of investing experience and discipline to manage the money wisely so it lasts.
Selling structured settlement payments
Selling structured settlement payments is often advertised as a way to free up money if you need cash now. It involves working with a factoring company that buys some or all of your future payments in exchange for money today. (Factoring companies are third-party businesses that specialize in purchasing annuity payments.)
But in reality, you’ll pay dearly to access those payments ahead of schedule, and there have been plenty of reports about unscrupulous factoring companies paying pennies on the dollar for settlements awarded to vulnerable individuals.
Settlement buyers won’t charge you a direct fee in most cases, but they will purchase your monthly payments at what’s called a discount rate. This means the sale isn’t a dollar-for-dollar exchange — you’ll always receive less than you would have gotten if you had waited for your scheduled payments.
According to the National Association of Settlement Purchasers, the average discount rate ranges from 9 percent to 18 percent. But it can go much higher, especially if you sell payments far into the future. If a buyer’s discount rate is noticeably higher than average, it’s a red flag.
How to cash out a structured settlement
There are regulations in place to protect owners of structured settlements, so if you pursue selling payments, you’ll need to follow several steps.
- Decide how much money you need: You can use an online structured settlement calculator to get a rough estimate of how much your payments might be worth.
- Find a factoring company: Look for companies with a strong financial track record and transparent pricing. Make sure to contact multiple factoring companies to compare quotes and terms.
- Review the contract with your lawyer and accept: Take your time and review all the fine print. Make sure to get a third-party professional, such as an attorney or financial advisor, to look over the contract before signing.
- Get the court to approve the sale: To cash out a structured settlement, you’ll first need to get court approval. Once you accept the offer, a court petition is filed by the factoring company to transfer the settlement. The judge ultimately decides whether to approve the transaction.
- Receive your money: This can take 60 to 90 days, according to JG Wentworth, a large factoring company.
In most cases, you won’t be taxed for selling a structured settlement so long as the settlement is for personal injury, illness, medical malpractice or wrongful death. Typically, if you don’t have to pay taxes on your structured settlement, the money you get from selling it won’t be taxed either.
Before making any decisions about selling payments, talk to a financial advisor. They can help you weigh the pros and cons, and find a reputable company to work with if you decide to move forward.
And remember, selling your payments can leave you without the steady income stream you were counting on, which could cause major financial issues down the road.
Bottom line
Receiving a big personal injury or illness settlement is life changing. But a huge influx of cash is notoriously difficult to manage — just look at lottery winners who deplete their winnings in a few short years. Unlike lottery winners though, money from a personal injury or illness case is meant to cover medical care, replace lost wages and provide a safety net for your future.
Structured settlements can protect that crucial lifeline so it’s there when you need it most. While they’re not for everyone, structured settlements can offer stability and peace of mind. With the right plan in place, you can make the most of your settlement and set yourself up for years to come.
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