Structured settlements are typically associated with personal injury, wrongful death, and workers’ compensation settlements. The federal tax code permits income tax exclusion for structured settlements used in injury cases, but when it comes to non-injury settlements, are structures still a favorable option?
Qualified Assignments vs. Non-Qualified Assignments
When a claimant elects to place settlement proceeds into a structured settlement, the defendant/insurance company assigns its obligation to make periodic payments over to a third-party assignment company. The assignment company then purchases a structured settlement annuity with the settlement proceeds, and the claimant begins receiving payments based on a pre-determined schedule.
To qualify for income tax exclusion, the assignment must meet the criteria laid out in Internal Revenue Code §§104(a)(2) and 130; personal injury, wrongful death, and workers’ compensation cases all qualify under these sections of code.
While non-injury settlement proceeds are not tax-free, a “non-qualified” assignment can still be utilized on certain types of cases to provide tax-favored treatment. If a non-qualified assignment is used to structure proceeds from a non-injury settlement, the taxes are deferred on the settlement proceeds and any earned interest. Taxes are payable only on the structure payments received in a given year.
Paula is a single mom living in Sacramento, California with her two young daughters. She works as a Medical Technician and makes $45,000/year. After complaining about a superior at work, she was fired from her job. Paula’s lawyer filed a wrongful termination lawsuit for which his client will receive $100,000 after paying attorney fees. Paula has two options for handling her settlement proceeds: 1) accept the entire settlement as a lump sum, or 2) divert her proceeds into a structured settlement annuity. After being fired, Paula found another job that pays her $42,000/year, keeping her in the 25% federal tax bracket. Because she lives in California, Paula also pays 8% in state income tax.
Option #1: Lump Sum
If Paula accepts her proceeds in the form of a lump sum, the money is taxable at the highest applicable tax rate. The $100,000, when combined with Paula’s current taxable income of $40,000, will bump her into the 28% federal and 9.3% state tax brackets. That puts Paula’s total marginal tax rate for the year at 37.3%, so she can say goodbye to a large chunk of her settlement.
Option #2: Structured Settlement
If Paula decides to structure her settlement proceeds, she could choose the payment amounts and payment schedule. For instance, she may want to supplement her $42,000/year income with an extra $20,000 broken down over 12 months. Instead of paying taxes on the full $100,000 lump sum, Paula will only be paying taxes on the $20,000 in structured settlement payments that she receives each year. When combined with her $40,000 income, Paula will pay 9.3% in state taxes but will be able to remain in the 25% federal tax bracket.
Which types of cases can utilize structured settlements via a non-qualified assignment?
Many types of cases that can leverage structured settlements via a non-qualified assignment, including:
Contact Traci Kaas to learn more