What Is a Structured Settlement or Annuity?

A structured settlement and an annuity are financial arrangements providing regular payments over time. These arrangements offer a predictable income stream, distinguishing them from single, upfront payments. While they share periodic disbursements, their origins, purposes, and structures differ.

Understanding Structured Settlements

A structured settlement is a negotiated financial arrangement to resolve a personal injury, wrongful death, or other claim, providing the claimant with periodic payments instead of a lump sum. This method offers long-term financial security to the injured party, especially in cases involving severe injuries that may require ongoing medical care or affect future earning capacity. Payments are typically scheduled over an agreed period, which can include payments for life, a set number of years, or delayed until a future date.

The parties involved in a structured settlement generally include the claimant (injured party receiving payments) and the defendant (often through their insurance carrier) who funds the settlement. An assignment company or qualified assignee may also assume the defendant’s obligation to make future payments. This transfer of obligation ensures the claimant receives payments even if the original defendant’s insurer faces financial difficulties.

Structured settlements are utilized in legal contexts, such as personal injury lawsuits (car accidents, medical malpractice, or workplace injuries). They also serve as compensation in wrongful death cases, providing ongoing financial support for the decedent’s dependents. The primary goal is to establish a reliable income stream, helping the claimant manage expenses like medical costs and living needs from the injury.

Understanding Annuities

An annuity is a financial contract with an insurance company, where an individual makes a lump sum or series of payments for regular disbursements. These disbursements can begin immediately or at a future date, providing a steady income stream. Annuities are often used as a retirement planning tool, addressing concerns about outliving savings by guaranteeing income for a specified period or the annuitant’s lifetime.

The operation of an annuity involves two main phases: the accumulation phase and the annuitization phase. During the accumulation phase, funds grow on a tax-deferred basis before payments begin. The annuitization phase, also known as the payout phase, starts when the insurance company makes regular payments.

Annuities come in various types, each designed to meet different financial objectives. Immediate annuities pay out soon after a lump sum is deposited, usually within a year. Deferred annuities delay payments until a future date, allowing invested funds more time to grow.

Fixed annuities offer a guaranteed interest rate and predictable payments, providing a stable income stream. Variable annuities allow investors to choose underlying investments, with payments fluctuating based on performance. Indexed annuities link returns to a market index, offering potential growth while providing some protection against market downturns.

The Connection: Structured Settlements as a Type of Annuity

While both involve periodic payments, structured settlements are typically funded by annuities, but not all annuities serve as structured settlements. A structured settlement is the overall financial arrangement or legal agreement to resolve a claim. A specific type of annuity, known as a structured settlement annuity, is the financial product used to fulfill its payment obligations. This annuity funds the series of payments to the claimant.

In most structured settlement arrangements, the defendant or their insurer purchases an annuity from a life insurance company. This annuity makes the agreed-upon periodic payments directly to the claimant. This ensures the payment stream matches the timing and amounts specified in the settlement agreement. Structured settlement annuities are designed to meet the unique requirements of a settlement, often featuring non-assignability, meaning payments generally cannot be sold or transferred without court approval.

The structured settlement results from a legal negotiation or court judgment, establishing a payment schedule. The annuity is the mechanism that guarantees and delivers those payments. An annuity can be a standalone financial product for retirement or other purposes, funded by an individual’s own money. In contrast, a structured settlement always arises from a legal claim, with the annuity serving as its funding vehicle. The structured settlement is the overarching agreement, and the annuity is the specific financial tool that facilitates its execution.

Tax Implications

Tax treatment of payments from structured settlements and general annuities differs. For structured settlements, payments received for personal physical injuries or sickness are generally excluded from gross income and are not subject to federal income tax. This tax-free status applies to both the principal and any interest or growth earned within the structured annuity. This favorable tax treatment is outlined in Internal Revenue Code Section 104(a)(2). Payments for wrongful death and workers’ compensation claims for physical injuries or illnesses also qualify for this exclusion.

Conversely, tax treatment for other annuities differs. While money invested in annuities grows on a tax-deferred basis during accumulation, earnings are generally taxable as ordinary income when withdrawn or received as payments. The portion representing a return of original principal is typically not taxable, as it is considered a return of capital. However, any earnings above the original investment are subject to income tax.

If withdrawals are made from a deferred annuity before age 59½, the taxable portion may be subject to an additional 10% federal tax penalty, unless an exception applies. Structured settlements for physical injuries offer a complete income tax exemption on both principal and growth. General annuities provide tax deferral during accumulation, with taxes due on earnings during payout. Tax rules can vary based on the specific annuity type and individual circumstances.