Nearly all structured insurance settlements are completely tax-free. This includes federal state taxes &, taxes on interest, dividends and capital gains, and the AMT. The reason for this is that the government believes that receiving compensation for physical injury, wrongful death, or workers' compensation is not an income gain. It is a restoration of the state before the loss.
However, if the client decides to invest their settlement funds, then the interest that grows on the investment is taxable. One way to avoid this is to establish a structured settlement annuity for the client to receive their settlement funds. All interest that grows within the structured annuity will also be tax-exempt. Payments received from a structured settlement annuity need not be reported on any tax return form (1040) or any tax document.
Both the principal amount and interest on the annuity are completely tax-exempt. The sale of annuity payments from a structured settlement will not be taxable as income, in general. However, in some cases there is a tax liability when selling those annuity payments, so it's important to plan accordingly. Similarly, the 1996 amendment determined that injuries must be physical or visible for the agreement to be excluded from gross income, so emotional distress recoveries that “do not originate from personal physical injury or physical illness must be included in your income and taxed accordingly.
Instead of paying a large lump sum, courts establish a system where the payer makes regular payments over a period of time. When a lawsuit is resolved in a court, especially a very large one, some courts allow the option of a structured settlement. Once both parties have agreed on the details of the structured agreement, the plaintiff releases the defendant (or insurer) from liability. You will not pay tax on structured settlement payments awarded as compensation in personal injury or workers' compensation claims.
The decision to use a structured settlement must be made before finalizing the settlement agreement. In situations where a worker is injured or suffers an illness due to their work, insurance companies may offer to pay the claim through a structured agreement. Congress passed the Recurring Payment Settlement Act of 1982 to encourage the use of structured settlements in cases of physical injury and wrongful death. Because structured settlements for compensatory damages are exempt from tax, so are profits from the sale of future payments.
The carrier then makes a series of periodic payments based on a pre-agreed term and amount. Although legislators prefer people to keep their structured agreements, there are no negative tax consequences to selling settlement payments. Collecting your settlement and reallocating that money to non-exempt investment vehicles would result in you owing taxes on dividends, interest, income, or capital gains. Accordingly, a benefit for customers who choose a structured settlement annuity is that they don't have to worry about reporting any future annuity payments as income in the year in which any payment is received.
Structured settlements are tax-efficient and can also have wasteful and asset protection advantages. Annuities allow the payee to appoint family members or friends to receive remaining annuity payments after the beneficiary's death.
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