If you (or your client) have been injured and are anticipating monetary damages, then you may benefit from a structured settlement annuity account. Annuities are preferred financial instruments when dispersing court awarded funds based on their safety, reliability and tax advantages.
Flexible annuity payments can account for the present and future needs of injured parties and their families. They can also protect against the dissipation of funds through mismanagement, taxes and market volatility.
A structured settlement is a payment of court awarded damages over a set number of years – or a lifetime. Payments are flexible and can be scheduled for any length of time depending on the needs of the injured party. Settlements can be taken as a lump sum in the future, as a stream of payments for a predetermined number of years, or as a combination of both.
Settlements typically arise from personal injury claims such as vehicular accidents, medical malpractice, product liability and/or workers compensation suits. In such cases, the plaintiff may be in need of financial stability for an extended period of time. In many cases, annuities are used in order to provide guaranteed future payments.
Annuities are established with monetary awards because they offer flexible payment schedules and predictable tax-free future income. Payments can be setup several different ways to account for ongoing future expenses for the injured party and his or her family. Future payments can be scheduled to increase over time to offset inflation or to provide for large expenses like ongoing medical care or a child’s tuition.
You are not obligated to deposit all of your awarded damages into an annuity. Oftentimes, a portion will be taken lump sum and the residual will be used to establish guaranteed future periodic payments. Payments can begin almost immediately or be deferred for a desired number of years.
Under Internal Revenue Code (IRC) section 104(a)(2), gross taxable income does not include damages received in a lump sum or through periodic payments due to physical illness or injury. In other words, the IRS considers structured annuity payments and earned interest from a settlement agreement as tax-free income to the recipient.
The funds used to purchase the structured settlement are income tax free provided certain conditions are met. The assignee (insurance company) must assume liability and this liability is to be no greater than the party who assigned it.
The periodic payments must be fixed and cannot be altered by the recipient. The payments must be excludable under the IRC section 104(a)(1). (Some may choose to sell their payment stream later however.)
Putting the legalese aside for a moment, the ruling treats annuity payments more favorably than other assets. If the entire monetary award is taken as a lump sum and invested in stocks or bonds, then the income generated from those investments would be taxable. If annuity payments are chosen however, then all future payments (principal and interest) would not be subject to income tax.
In a nutshell, a lump sum investment in the market would need to provide much higher returns in order to offer the same tax-free payments as the deferred annuity. Put another way, taxes associated with market investments will decrease your overall returns.
Unfortunately, many settlements taken in a lump sum dissipate after only a few years. In fact, studies show that lump sum settlements tend to be exhausted after only five years or less. Conversely, structured settlements taken as periodic payments are designed to provide benefits for several years and are therefore difficult to mismanage.
Annuities offer a fixed internal rate of return on your invested principal. The structured settlement payments are treated more favorably by the IRS. They help to avoid spendthrift situations where the damages are taken lump sum, invested poorly and frivolously spent. This is also why court approval can be necessary in order to sell an income stream.
Taxes will diminish any returns on your investment. Annuity accounts avoid income taxes altogether when established as part of a structured agreement. If there is concern about future obligations, safety of principal, and investment flexibility – then an annuity from a well-capitalized and highly-rated insurance carrier can be a wise choice.