Structures Annuity Settlement
What is a Structured Settlement?
When most people receive unexpected cash, their first impulse is to spend it. Whether a person wins the lottery, receives an inheritance, is offered early retirement benefits or settles an insurance claim, odds are that, unless something is done to protect it, the cash will soon disappear. To help safeguard personal injury settlement recipients from bad investments, unscrupulous friends or family, and unwise or frivolous purchases that can quickly deplete settlement funds, a concept entitled Structured Settlements was developed in the late 1970s. Shortly thereafter Congress authorized federal income tax incentives to encourage the use of structured settlements through enactment of the Periodic Payment Settlement Act of 1982 (Public Law 97-473).
How Does a Structured Settlement Work?
The decision to utilize a structured settlement must be made before finalizing the settlement agreement. Once both parties have agreed to the details of the structured settlement, the claimant releases the defendant (or insurer) from liability.
The defendant or insurer then pays the settlement funds to a third-party assignment company, which assumes liability and purchases an annuity from a structured settlement carrier. The carrier then makes a series of periodic payments based on a previously agreed.
Benefits of a Structured Settlement
100% INCOME-TAX-FREE FOR PHYSICAL INJURY AND WRONGFUL DEATH CASES:Payments (including growth) for physical injury and wrongful death cases are free from state and federal income tax under Section 104(a) of the Internal Revenue Code.
100% INCOME TAX-DEFERRED FOR NON-PHYSICAL INJURY CASES:Payments (including growth) for non-physical injury cases are tax-deferred.
GUARANTEED PAYMENTS1:The schedule of payments is determined on the front end of the transaction, resulting in a steady source of safe, reliable income for the claimant.
GUARANTEED RATE OF RETURN:With a locked-in rate of return, injured claimants can rest assured that market volatility will not affect their structured settlement payments.
NO OVERHEAD FEES OR EXPENSES:The lack of overhead fees combined with the preferential tax treatment allow structured settlements to remain competitive with traditional investments.
Structured Settlements and Annuities
Structured settlements are linked to annuities because they’re considered an effective way to deliver money to people who need it but also need the discipline of a monthly or yearly payout. Congress in 1982 passed the Periodic Payment Settlement Tax Act, which established structured settlements to provide long-term financial security to accident victims and their families.
The idea was to replace lump-sum payments awarded to personal injury claimants with periodic payments. The government’s aim was to decrease the number of personal injury award recipients who went through their funds too quickly and were subsequently forced to rely on public assistance. In addition to personal-injury claimants, structured settlements are frequently set up for those who win big liability and damage judgments, for lottery winners and for lawyers and law firms who are owed large sums in fees.
Because annuities can be designed to offer timed payouts, guarantees on principal, as well as investment gains, and were already being offered by insurance companies, they quickly became the preferred vehicle to implement structured settlements. To encourage their use, the new law made any interest or capital gains earned on the annuity within a structured settlement tax free.
Pros and Cons of Annuities
The primary reason to own an annuity is security. In addition to ensuring a continuing stream of income during one’s retirement, many annuities are guaranteed for a minimum rate of return, meaning that not only can their principal be protected against loss; their earnings can be, as well. In some cases, by annuitizing the contract, the owner of an annuity can even receive a life-long stream of income, far more than his or her original investment.
Annuities also offer predictability. Fixed annuities – ones tied to an unwavering interest rate – are especially attractive to investors who want to know how much money they will have years, or even decades into the future. They generally offer rates superior to money market accounts or certificates of deposit (CDs), and come with similar built-in protections and guarantees.
Conversely, variable annuities – ones tied to rising and falling rates – offer the possibility of returns equal to those achieved via stocks or mutual funds, but with greater flexibility, more protections against loss, and certain tax advantages.
Other things to consider: Annuities come with fees, often high ones. The broker who sells you an annuity usually receives a commission, and the company that manages the annuity charges an annual maintenance fee. If the annuity is invested in mutual funds, the funds’ fees become part of the cost.
Since annuities are insurance products, their structure reflects the risk the insurer assumes. For instance, the value of a variable annuity invested in mutual funds varies with the value of the funds, which can go down. If the annuity guarantees a minimum periodic payout, the annuity costs will reflect the risk the insurer takes, and that risk is a premium built into the cost of the annuity. Some annuities also lock in your gains after a certain take, which also adds to the risk the issuer incurs. Again, that risk means extra fees built into the annuity.
The biggest con for annuities is that you must be 59 and a half to with draw the gains from an annuity and not have to take a 10% early withdrawal penalty. There also will be a surrender charge if you try to withdraw early. The charge goes own over time, but if you need the money now, you will pay a penalty.
Another negative for owning an annuity is that many of them charge higher annual fees, especially on variable annuities than those charged on managed mutual funds or stocks. Also, the current interest rates are so low that inflation could easily go up faster than the return on interest you would receive with an annuity.
There are negative tax implications associated with annuities. Gains on annuities are taxed as ordinary income, meaning you could pay twice as much in taxes on it as you would from the capital gains on stocks or mutual fund investments. Another tax penalty comes if you pass along annuity benefits to your survivors after your death. They will have to pay taxes on it as ordinary income.