If you've won an injury or malpractice court case, the defendant may offer to structure settlement payments through an annuity. This converts your compensation into steady income that helps you manage expenses for many years. A structured settlement may fit some claimants' needs and not others; whether it is appropriate depends on the nature of the claim, the claimant's medical and financial situation, tax considerations, and other factors. Before moving forward with a structured settlement annuity, read the following educational overview and discuss the specific terms with your attorney, a settlement-planning professional, and a tax advisor. Structured settlements are legal instruments governed by federal tax law and by the Structured Settlement Protection Act of the state in which the payee resides; this article is not legal, tax, or financial advice.
What is a structured settlement annuity?
A structured settlement annuity is an annuity contract used to fund a series of periodic payments to a plaintiff who has settled a personal physical-injury, physical-sickness, or wrongful-death claim. When the underlying damages qualify, the periodic payments received by the claimant are excluded from federal gross income and, in most states, from state income tax. The scope of the exclusion is important: it covers damages received on account of personal physical injuries or physical sickness. It generally does not exclude punitive damages, employment-discrimination damages, most emotional-distress damages (unless attributable to a physical injury), or interest on the judgment. Consult a tax advisor for the tax treatment of a particular settlement. Instead of a lump-sum payment, a life insurance company issues an annuity that pays out in one of the following ways.
Lifetime payments
Lifetime payments continue for the rest of the recipient's life. The insurer calculates the schedule using life expectancy at the time of the settlement. Payments end at the recipient's death unless the contract includes a guaranteed period (see 'Guaranteed period vs. life contingency' below).
Fixed-term payments
Fixed-term payments last a set number of years, determined during settlement negotiations. Payments stop at the end of the period, even if the recipient is still alive. Payments continue to the designated beneficiary if the recipient dies during the fixed term, provided the contract so specifies.
Lump sums combined with periodic payments
Some plaintiffs need to cover legal or medical bills immediately. If so, they may choose to receive part of their settlement in a lump-sum payment upfront and receive the rest through periodic payments. The initial lump sum and each scheduled periodic payment that qualifies retains the tax exclusion.
How structured settlements are created
Before entering into a structured settlement agreement, it helps to know what to expect. Once the terms are finalized, they're difficult to modify. Payments generally cannot be assigned, sold, pledged, or otherwise transferred except through a court-approved sale under the applicable state Structured Settlement Protection Act (see 'Selling future payments' below). Here are the key stages in the process.
1. Settlement terms are negotiated
A structured settlement begins when the plaintiff and defendant agree on compensation for the lawsuit. An attorney helps negotiate the terms and confirms the payout meets the claimant's needs. Once the parties finalize the agreement, the defendant must fund the obligation.
2. An assignment company may purchase the obligation
In most structured settlements, the defendant or its liability insurer transfers the obligation to make the periodic payments to a 'qualified assignment' company (typically an affiliate of the annuity issuer) through a qualified assignment. The assignment company then purchases a structured settlement annuity from a life insurance company to fund the assumed periodic-payment obligation. When the requirements are met, the assignment company excludes the assignment consideration from gross income, and the ongoing periodic payments retain the exclusion in the payee's hands.
3. A payment structure is selected
The plaintiff selects how to receive payments. Options include lifetime income, fixed-term payments, or a blend of lump-sum and periodic deposits. Once the insurer issues the annuity, the terms become permanent, so careful planning is important. The payment schedule is fixed at issue; the payee cannot generally accelerate, defer, or change the payments after the fact.
4. Payments are issued over time
The assignment company directs the insurer to send payments to the plaintiff according to the agreed schedule. This creates a predictable flow of income that helps manage immediate needs and support future stability.
Structured settlement annuities vs. traditional annuities
Structured settlements and traditional annuities adhere to separate rules and serve different functions. A traditional annuity is a long-term investment account, often used by people saving for the future. Account holders make contributions over time and receive payouts at the end of the accumulation period, usually in retirement.
People don't purchase structured settlements voluntarily like they would a traditional annuity. Instead, they're created after a lawsuit. The following table shows some key differences.
Funding Source
- Structured Settlement Annuity: Funded by the defendant or its liability insurer through a qualified assignment under IRC §130 to an assignment company that then purchases the annuity.
- Traditional (Retail) Annuity: Purchased directly by an individual with after-tax funds (non-qualified) or with qualified-plan/IRA funds.
Taxation
- Structured Settlement Annuity: Periodic payments attributable to damages excluded under IRC §104(a)(2) (personal physical injuries or physical sickness) are excluded from federal gross income. Payments attributable to punitive damages, non-physical-injury claims, employment-discrimination damages, or pre/post-judgment interest are generally taxable. State tax treatment generally follows federal, but consult a state tax advisor.
- Traditional (Retail) Annuity: Non-qualified annuities: earnings grow tax-deferred and are taxed as ordinary income on withdrawal; a 10% federal additional tax under IRC §72(q) may apply to withdrawals of earnings before age 59½. Qualified annuities: subject to the tax rules of the underlying qualified plan or IRA.
Flexibility
- Structured Settlement Annuity: Payment schedule fixed at issue. Sales or "commutations" of future payments require state-court approval under the applicable Structured Settlement Protection Act and may trigger the 40% excise tax on the buyer under IRC §5891 if court approval is not obtained.
- Traditional (Retail) Annuity: Contract terms may allow limited penalty-free withdrawals, riders, and beneficiary changes; may impose surrender charges and MVA.
Purpose
- Structured Settlement Annuity: Provides court-facilitated periodic income to a claimant (or beneficiaries) in a physical-injury, medical-malpractice, or wrongful-death matter.
- Traditional (Retail) Annuity: Long-term savings, tax-deferred accumulation, and/or retirement income.
Guarantee
- Structured Settlement Annuity: Backed by the claims-paying ability of the issuing life insurance company. State insurance guaranty association coverage varies by state and is subject to statutory caps.
- Traditional (Retail) Annuity: Backed by the claims-paying ability of the issuing life insurance company. State insurance guaranty association coverage varies by state and is subject to statutory caps.
Structured settlement payments vs. lump-sum payments
When a plaintiff wins a case, they can generally choose whether to receive a structured settlement or a lump-sum payment. Each has different tax, cash-flow, and risk characteristics; the appropriate choice depends on the claimant's medical status, ability to work, financial sophistication, tax profile, and other resources.
Pros of structured settlement annuities
Structured settlements provide a scheduled stream of payments backed by the claims-paying ability of the issuing insurer. When funded from qualifying damages, payments are excluded from federal income tax, which on an after-tax basis can be materially more favorable than an equivalent taxable investment return on a lump sum.
Cons of structured settlement annuities
Structured settlement annuities offer limited flexibility. It's difficult to change the payment schedule after you set it and the insurer issues the annuity. You also can't access funds when you want, which can be challenging if emergencies arise.
Structured settlement annuities credit interest at the rate embedded in the contract at issue, which may be higher or lower than yields available on other investments over time. A comparison of structured-settlement 'returns' to lump-sum-invested returns should be made on an after-tax basis, since qualifying structured-settlement payments are excluded from federal income tax while investment returns on a lump sum are generally taxable.
Pros of a lump sum
A lump-sum payment provides immediate liquidity, which may be needed to pay legal fees, medical bills, or other urgent expenses. It also permits the claimant to select any investment strategy and to retain control of the principal.
Cons of a lump sum
Managing a large payout requires discipline. You're on your own to manage this money, and you could spend the money too quickly or make poor financial decisions. Once you've spent the funds, you won't receive more in the future. Investment returns on the lump sum are generally taxable, unlike qualifying structured-settlement payments. Recipients receiving means-tested government benefits (e.g., SSI, Medicaid) may find that a lump sum affects eligibility, whereas properly structured periodic payments and/or a special-needs trust may preserve eligibility; consult a benefits attorney.
Benefits and considerations of structured settlement annuities
Tax advantages
Under IRC §104(a)(2), damages received on account of personal physical injuries or physical sickness are excluded from federal gross income, and this exclusion applies whether the damages are paid in a lump sum or as periodic payments under a structured settlement. Most states also exclude these amounts from state income tax, though state treatment can vary. The exclusion does not apply to punitive damages, most emotional-distress damages not attributable to a physical injury, employment-discrimination damages, or pre-judgment/post-judgment interest, all of which are generally taxable when received. If a settlement includes both qualifying and non-qualifying damages, allocation among the categories has tax consequences and should be documented in the settlement agreement.
Long-term financial security and care
Structured settlement annuities provide a scheduled payment stream that can be tailored to anticipated future medical, custodial, or living expenses. Because the schedule is fixed at issue, structured settlements provide budgeting certainty but not flexibility if circumstances change.
Key terms to review in a structured settlement agreement
The plaintiff's attorney should review each of the following terms in the settlement agreement and the annuity contract. This list is not exhaustive:
- Payment start date and schedule: when payments begin and how often they are made.
- Annual increases / COLA riders: optional add-ons that raise payments each year to counter inflation. COLA amounts are fixed in the contract at issue; they do not adjust to actual future inflation.
- Guaranteed period vs. life contingency: guaranteed-period payments are made over an established timeframe regardless of whether the payee is living; life-contingency payments continue only for the payee's life. Where a guaranteed period is combined with a life contingency, payments continue for the greater of the guaranteed period or the payee's life. If the payee dies during a guaranteed period, remaining payments pass to the designated beneficiary.
- Beneficiary and commutation terms: the payee can designate beneficiaries to receive remaining guaranteed payments. Some contracts include a 'commutation' rider under which the remaining payments may be paid to a beneficiary as a discounted lump sum on the payee's death. Commutation to a living payee is generally not permitted.
- Assignment rules and anti-assignment provisions: structured settlements typically prohibit the payee from voluntarily assigning or pledging future payments. Sales of future payments to a factoring company require prior approval by a state court under the Structured Settlement Protection Act of the payee's state of residence and must comply with the state's 'best-interest' or 'necessary support' standard. Sales without such approval subject the buyer to a 40% federal excise tax under IRC §5891.
- Issuing insurer identity, rating, and guaranty-association coverage: because structured-settlement payments are backed only by the claims-paying ability of the issuing insurer (and, subject to statutory limits, the state insurance guaranty association), the identity and financial strength of the issuer are material.
Are structured settlement annuities guaranteed?
Structured settlement annuities are not deposits and are not insured by the FDIC or any federal government agency. The payments are the obligation of the issuing life insurance company and are subject to that insurer's claims-paying ability.
Structured settlements are frequently considered in the following situations. Whether a structured settlement is appropriate for a particular claimant is a decision for the claimant, the claimant's attorney, and any settlement-planning professional or trustee involved in the matter:
- Minors: Settlements involving minors often use a structured payout combined with court-ordered protective mechanisms (e.g., a guardianship, blocked account, or minor's trust) so payments are administered under court oversight until the minor reaches majority or a scheduled age.
- Claimants with ongoing medical or care needs: a scheduled income stream can be aligned with anticipated future medical or custodial expenses.
- Claimants receiving means-tested public benefits: a lump sum may affect eligibility for SSI, Medicaid, or similar programs; structured settlement payments — often combined with a special-needs trust — may be used to preserve eligibility. This is a highly specialized area; consult a special-needs or elder-law attorney.
- Claimants who are unable to work as a result of the injury: a scheduled income stream may substitute for lost earning capacity.
- Claimants who prefer scheduled income to a lump sum: some claimants prefer a scheduled income stream over the responsibility of managing a large lump sum.
- Pre-retirement recipients: Structured settlements provide bridge income if you're at the end of your career but can't yet access retirement funds. These payments can supplement income or help with major expenses, like remodeling your home.
Selling or 'commuting' future payments
After a structured settlement is in place, a payee may be approached by a 'factoring company' offering a discounted lump sum in exchange for the right to some or all of the future payments. These transactions are regulated at two levels:
- State law: every state has adopted a Structured Settlement Protection Act (SSPA) requiring prior court approval of any transfer of structured-settlement payment rights. The court applies a 'best interest' or 'necessary support' standard and may require independent professional advice for the payee.
- Federal tax law: IRC §5891 imposes a 40% federal excise tax on the factoring company (not the payee) if a transfer does not receive the required state-court approval, effectively eliminating the market for unapproved transfers.
Discount rates applied by factoring companies are typically substantially higher than prevailing interest rates, and the effective present value received by the payee is often significantly less than the discounted present value of the payments sold. A payee considering a sale should obtain independent legal and financial advice before agreeing to a transaction.
NOT A DEPOSIT • NOT FDIC-INSURED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY • NOT GUARANTEED BY THE BANK • MAY LOSE VALUE (if surrendered early)
This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. The Gainbridge® digital platform provides informational and educational resources intended only for self-directed purposes.
