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What are the Taxes on Structured Settlements and Annuities?
When you receive a structured settlement, you are set to receive money sometime in the near future. Whenever you have money coming in, it becomes a possible tax issue. The tax rules for structured settlements are a little complicated because the IRS considers some of these payments taxable and others tax-free. Understanding these different rules will help you better plan your finances and avoid any surprises come tax season.
Court-Ordered Structured Settlements
One way to receive a structured settlement is through winning a court judgment. This typically happens when someone else causes you to get sick or injured like in a car accident, medical malpractice, or bad conditions at your job. The IRS created fairly generous tax laws regarding court ordered settlements to help Americans deal with their problems. Otherwise, it would be more likely that these people would need help from the government. As a result of this favorable tax treatment, a significant amount of court-ordered structured settlements are tax-free.
Non-Taxable Court Structured Settlements
You do not owe any income tax on structured settlements that are considered compensatory damages. This is the money that you receive to make up for your physical damages. The court decides how much your pain or suffering is worth as part of your judgment. For example, if you end up in a wheelchair because of a car accident and the court decides your pain, suffering and loss of mobility are worth $100,000, you’ll receive all that money tax-free. It doesn’t matter whether the payment is in installments or a lump-sum; all the compensatory payments are tax-free.
You also won’t owe any income tax on money received to cover your medical bills. This is the same as receiving insurance payments. Since you aren’t gaining anything financially from having your bills paid, it isn’t income. Lastly, if you get hurt or sick while working and receive a structured settlement as part of a worker’s compensation claim, this money is also tax-free.
Taxable Court Structured Settlements
If you win your judgment, you could also receive extra money on top of your compensatory damages. These payments are called punitive damages. Punitive damages aren’t meant to make up for your injury or illness but rather are used to punish the offending party for being reckless and hurting you. This money is considered to improve your financial position as it isn’t making up for your lost health. As a result, the part of your structured settlement that represents punitive damages is taxable as income.
If you need to leave the workforce due to your injury or illness and your receive money from your settlement to replace your lost income, these payments are taxable. Since you would have owed this income tax had you kept working, you also owe it as part of your structured settlement. Business damages like breach of contract and patent infringement are also taxable. These payments are also replacing your lost income so you need to pay tax when it comes in.
Compensatory payments for physical damages like an injury or illness are tax-free but compensatory payments due to emotional damages are not. If you win a workplace discrimination suit or a slander suit, the compensatory payments are taxable. However, if you become ill because of emotional distress and need medical care, any money that you receive to cover medical bills is tax-free.
If you don’t take your structured settlement as a lump-sum payment, the money will be invested in a safe account to earn interest. When you receive future payments, the earned interest is also taxable. Lastly, if the court orders the losing party to pay your legal fees, this money is also taxable.
If you owe income tax on some part of your structured settlement, you’ll owe the taxes when you receive your money. If you take a lump-sum payout, your entire tax liability is due at once. If you take periodic payments, you only owe taxes on the part of your settlement that you receive each year.
Lottery Structured Settlements
Another way to receive a structured settlement is by winning the lottery. All the money you win from a lottery is taxable; it doesn’t have the same tax benefits as court judgments. If you win a lottery cash prize, you have the choice between taking a lump sum payment or periodic payments. When you take the lump sum payment, your entire payment is taxable. If you take a structured settlement, your payments each year are taxable as income.
Some lottery winners initially take the installment payment option and then change their minds; they later want a lump sum. In this case, you can sell your future lottery payments to a company that manages structured settlements. Through this sale, you assign all future lottery payments to the company and they give you a lump sum payment. When you make a sale, everything you receive from the sale is taxable as income.