What Is a Structured Settlement and How Does It Work?

A structured settlement is a financial agreement designed to provide individuals with a series of payments over time, rather than a single, immediate lump sum. This arrangement is commonly established in situations involving personal injury claims or other legal settlements where ongoing financial support is beneficial. It offers a predictable stream of income, often tailored to meet future financial needs such as medical expenses or living costs. The primary goal of a structured settlement is to ensure long-term financial stability for the recipient, distributing funds systematically over an agreed-upon period.

Core Definition and Structure

A structured settlement is an agreement where a claimant receives compensation through periodic payments rather than one large payment. These arrangements typically arise from legal claims like personal injury lawsuits, wrongful death cases, or workers’ compensation claims. The key parties involved include the claimant, who is the recipient of the payments, and the defendant or their insurer, who is the payer. To fund these periodic payments, the defendant or insurer purchases a specially designed annuity from a life insurance company.

This annuity serves as the financial instrument guaranteeing the future stream of payments to the claimant. The payments are typically fixed and scheduled over a specific period, or sometimes for the recipient’s lifetime. This structure ensures a steady and dependable income, removing the burden of managing a large sum of money at once. The arrangement is often established to provide financial security and stability for the claimant’s ongoing needs.

How Structured Settlements Work

The process of establishing a structured settlement involves several steps, central to which is the concept of a qualified assignment. After a settlement agreement is reached, the defendant or their insurer transfers their periodic payment obligation to a third-party assignment company. This assignment company then assumes the responsibility for making the future payments to the claimant. The use of a qualified assignment, as defined under Internal Revenue Code Section 130, is an element that helps maintain the tax-free status of the payments for the recipient.

The assignment company funds its payment obligation by purchasing a single premium annuity from a highly-rated life insurance company. This annuity is designed to match the payment schedule agreed upon in the settlement, which can include fixed monthly payments, payments that increase over time, or payments scheduled for specific future dates. Once the structured settlement is established, the payment schedule is generally set and cannot be easily changed by the recipient. This fixed nature provides long-term financial predictability but also limits immediate access to the full settlement amount.

Common Applications

Structured settlements are commonly used in specific types of legal claims where long-term financial support is a significant consideration. They are frequently utilized in personal injury cases to compensate individuals for medical expenses, lost wages, and pain and suffering resulting from an accident. Wrongful death claims also often incorporate structured settlements to provide ongoing financial support for surviving family members, addressing the loss of income and future contributions.

Workers’ compensation cases represent another common application, offering injured workers a steady income stream to cover medical costs and lost earnings over an extended period. The structure of these settlements is particularly beneficial in situations where a claimant faces lifelong medical needs or a permanent inability to work. By providing predictable payments, structured settlements help ensure a claimant’s financial well-being without the risk of quickly depleting a large lump sum.

Tax Implications

A significant advantage of structured settlements lies in their favorable tax treatment under specific provisions of the Internal Revenue Code. Payments received from a structured settlement for physical injury or physical sickness are generally excluded from gross income under Internal Revenue Code Section 104. This means that both the principal amount and any interest earned on the annuity are typically tax-free to the recipient. The same tax-free status generally applies to payments arising from workers’ compensation claims.

This tax exclusion provides a substantial benefit, as the recipient does not owe federal income tax on the periodic payments. However, it is important to note that this tax-free status typically does not extend to payments for punitive damages, which are generally taxable. Additionally, settlements for non-physical injuries, such as emotional distress not stemming from a physical injury, may also be subject to taxation. Proper structuring is essential to ensure compliance with Internal Revenue Service (IRS) regulations and to secure the intended tax benefits.

The Secondary Market

While structured settlements offer long-term financial security, circumstances can arise where recipients need immediate access to a larger sum of money. This need led to the development of a secondary market for structured settlements. In this market, a recipient can sell some or all of their future periodic payments to a factoring company in exchange for a lump sum of cash. This process provides liquidity but typically involves selling the payments at a discount to their total future value.

The sale of structured settlement payments is a highly regulated process designed to protect the seller. Most jurisdictions require court approval for such transactions, ensuring that the sale is in the best interest of the claimant. The court reviews the terms of the sale, including the discount rate applied by the purchasing company, to determine if the lump sum offered is fair and reasonable given the future value of the payments. This oversight helps prevent predatory practices and ensures transparency in these transactions.