If you've recently been awarded a legal settlement in the form of an annuity -- rather than a lump sum payment -- you may be wondering about the practical, financial, and legal considerations of this award. Structured settlements can provide a number of advantages over lump sum payments (particularly if the lump sum payment is partially or fully taxable) -- however, these settlements can also carry some complications. Read on to learn more about how a structured settlement works, as well as a few situations in which you might want to consider pursuing a structured settlement buyout.
What is a structured settlement?
A structured settlement is simply an alternative to the more traditional lump sum settlement received for many types of legal claims. For example, if you've sued someone for injuries you've suffered in an auto accident, the defendant's insurance company may opt to reduce its immediate costs by offering you a structured settlement that will provide you a fixed monthly or annual income for the rest of your life, rather than a lump sum you'll receive immediately.
In other cases, a court may order a settlement to be awarded in this manner. This is most common when the court has determined such a settlement will be beneficial to you -- for example, if the settlement is designed to replace your regular income, the court may determine that you'll be best served by getting regular payments (rather than receiving a lump sum you may spend immediately, and then find yourself receiving government assistance when the funds have run out).
How are structured settlements taxed?
Whether you receive a settlement in a lump sum or as a structured settlement, this amount may be subject to income tax. However, the amount of tax levied on your settlement will primarily depend upon the purpose behind the court's award. If your settlement or judgment was designed to compensate you for medical expenses or pain and suffering associated with the event that led to a lawsuit, it won't be taxed. However, if this settlement or judgment was designed to punish the defendant (punitive damages), or to compensate you for wages or other income you may have lost, it will be taxed just as your other income is. If you receive a lump sum payment, you'll owe these taxes for the calendar year in which this payment was made.
When is a lump sum settlement buyout a better option?
Even if a court has awarded you a structured settlement for a specific reason, you always have the option to have your settlement bought out by a company that specializes in this type of transaction. This will provide you with a lump sum in exchange for your relinquishment of the right to collect on your structured settlement. The amount you'll receive is generally calculated to closely correlate to the purchase price of an annuity that would provide you with the same amount of income you're receiving through your structured settlement.
In many cases, a lump sum can provide advantages. If the majority of this settlement isn't taxed, you may benefit from receiving this money now, rather than a small portion of the total each month or year. You might need to catch up on past due bills, help make your home handicap-accessible, or pay off debts.
However, two situations in which a lump sum buyout may not be the best option are when you're preparing to declare bankruptcy or when your annual structured settlement payments are below the threshold that would catapult you into a higher tax bracket. In many cases, it may not be worthwhile to receive a lump sum if you'll end up paying a much greater amount in taxes. And if you receive a lump sum before declaring bankruptcy, this money may be subject to seizure and disbursement to your various creditors. Waiting until after you've declared bankruptcy to do additional reading and possibly pursue this option could provide you with greater leverage.