You won't pay taxes after you sell payments from most structured settlements and workers' compensation claims tied to physical injury or sickness. Selling other annuity payments may enable taxpayers to deduct a loss.
One of the most common questions about selling a structured settlement is whether the lump-sum payment can be taxed. The answer, is no.
The Periodic Payment Settlement Act, passed by Congress passed in 1983 to encourage structured settlements as a way to provide long-term financial security to accident and injury victims and their families, forbids the IRS from taxing this income. It doesn’t matter if the income gets paid all at once or in future installments. Either way, the Internal Revenue Service doesn’t get a piece of it.
There is, however, one exception. If the original contract is changed, the proceeds can be taxed.
Let’s go through some of the possible scenarios that impact taxes on annuity and structured settlement transfers and sales. A quick now, these are for informational purposes and should not be considered tax advice. Always consult a tax professional if you need specific information about your potential tax consequences.
All periodic and lump-sum payments in settlements of physical injury, physical sickness or wrongful death claims, including any interest or capital gains, are free from federal, state and local income taxes.
That includes the interest income earned through the duration of payments.
In return for this potentially lucrative tax exemption, the recipient of this kind of settlement can’t modify a previously approved payment schedule. If the original contract changes, payments immediately become taxable income.
Because of the Taxpayer Relief Act of 1997, insurance companies can issues structured settlements in workers’ compensation cases, which cover physical injuries suffered in the workplace. That law extends to the government’s tax-free advantages of these claims. Workers’ compensation claims must meet certain requirements to be considered a structured settlement. Section 104 (a)(2) of the Internal Revenue Code (IRC) specifies that damages from personal injury and sickness are not viewed as income, therefore not subject to tax. Section 130 allows for an assignment of obligation to a third party. This code gives the recipient of payments the ability to transfer their obligation and keep all tax-free advantages in place.
There are some exceptions. If you receive payments from a settlement stemming from a workplace dispute that doesn’t involve physical injury or illness, you likely won’t qualify for tax-free status when you transfer your payments.
Through an IRC Ruling in 2002, the federal government began reinforcing state laws by charging certain annuity purchasing companies a federal excise tax. It’s calculated as 40 percent of the expected gross profit the purchaser will make on the transaction.
The penalty applies to funding companies buying payments without petitioning for a judge’s approval. Legislation discourages buyers by adding this hefty fee when a judge is not consulted to deem a transfer in the seller’s best interest.
Structured settlement and annuity owners don’t pay the excise tax. While you may read about this tax and start to panic, a closer look will show that the IRS developed this tax amendment to protect you.
While you can sell the payment rights to a number of types of annuities (except those held in retirement-specific, IRA accounts or life-only immediate annuities), you’ll have to pay income taxes on any realized gains and on any previously taxed earnings.
For example, if you sell a tax-deferred contract that you purchased yourself, there will be a federal income tax liability for any deferred earnings and an additional federal 10 percent penalty if you’re younger than 59½.
The potential income tax liability is determined by evaluating the earning portion of your annuity. In addition, any gain on the sale of an annuity contract before its maturity date will be taxed as ordinary income. Always consult your tax professional before making any important financial decision.
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Just as with any potential annuity gains, always consult your tax professional to determine the best course of action for deducting potential annuity losses.
When the value of an annuity decreases, the IRS does not view this as an investment loss. This means it cannot be used to reduce other capital gains or as a capital loss carry-over. Taxpayers may, however, be able to use the loss to offset other ordinary income. (IRC Revenue Ruling 61-201 allows for a loss deduction when an annuitant surrendered a single premium refund annuity contract and received less than the cost basis. It’s also important to note that surrender charges themselves are not considered deductible.)
To find out if this scenario applies to you by beginning with your cost basis. The cost basis refers to the amount you originally paid for the annuity minus any principal payouts you have already received. To calculate a potential loss, compare your cost basis to the amount you sell your annuity for.
The following are circumstances in which you may be able to deduct an ordinary loss:
The stock market impacts the value of variable annuities. When stocks tied to annuities are under-performing, investors may decide to sell the asset and claim the difference between the original amount paid for the annuity and the amount the annuity sells for.
Example: An investor purchases a variable annuity for $80,000 with payments deferred for five years. During that time, the stock market performs poorly and the annuity value drops to $60,000. Investors have a few options.
They can keep the annuity, accept smaller periodic payments and hope the market improves or they can cash out one of two ways:
Investors who own fixed immediate annuities (ones that aren’t tied to the stock market), like a single premium immediate annuity, may choose to sell payments for a lump sum of cash. Even though these don’t lose value because of the stock market, the investor may be able to deduct a loss because of the discount rate.