In most cases, selling the annuity payments from your structured settlement incurs no tax liabilities. But state and federal laws outline some situations when taxes must be paid, and you should always consult a tax professional for information about your specific situation.
Are Structured Settlements Taxable?
For anyone selling a structured settlement, the most common question is whether a lump-sum payment can be taxed. In almost every case, the answer is no.
The IRS is barred from taxing structured settlement income — whether it’s paid all at once or in installments — under the federal Periodic Payment Settlement Act. The law is designed to ensure structured settlements continue to provide financial security to those who received them.
However, there are different tax implications associated with the most typical types of transactions involving structured settlements.
Taxes for Personal Injury and Wrongful Death Lawsuits
In every case, any installment or lump-sum payments due to injury, sickness or wrongful death claims are exempt from any federal, state and local taxes. That includes capital gains or any interest earned throughout the duration of installment payments.
Annuities built from insurance settlements are the most common form of structured settlement vehicles. In the case of personal injury and wrongful death awards, these structured settlements are considered “nonqualified” by the IRS, meaning the money is tax exempt.
Taxes for Workers’ Compensation Structured Settlements
Insurance companies can also offer structured settlements in workers’ compensation cases that involve physical injuries or illnesses suffered in the workplace.
Section 104 (a)(2) of the Internal Revenue Code mandates that damages from on-the-job physical injuries or illnesses cannot be considered income, so they are not subject to taxation.
Section 130 of the IRC also allows payment recipients to sell their future payments, such as those scheduled to happen during the next 10 years, with all the same tax-free advantages in place.
Taxes for 1035 Exchanges
Someone who wants to buy a replacement contract for their structured settlement annuity can do so tax-free under Section 1035 of the IRC. The code also says rollovers or direct transfers from one insurance company to another can be done tax-free.
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For example, if you find an annuity contract with a higher interest rate, lower fees or want a contract issued by a more stable company, you’ll be able to exchange your current annuity contract without incurring any additional tax burdens.
Taxes for Partial Annuitization
This is a middle-of-the-road approach that allows you to take some of the money from your structured settlement now and leave the rest to grow. For example, you could take $100,000 in a lump sum from a $300,000 structured settlement. Although the lump sum will be subject to taxes, the rest of the money can be left in the annuity account to grow tax-free.
Structured Settlement Tax Exceptions
There are a number of exceptions to the tax-free rules regarding the sale of structured settlements. Here are some potential situations that would incur a tax liability.
Tax Implications for Qualified Annuities and Modified Payments
The IRS defines qualified annuities as those funded with pre-tax dollars. While they may be eligible for tax deductions, any distributions made from them are subject to income taxes.
So if you had a $100,000 annuity that was purchased with pre-tax dollars, the entire balance would be taxable. If that same annuity was bought with after-tax money, only the earnings on it would be taxable.
Additionally, owners of structured settlements who want to modify their original contracts should be aware that doing so makes any future payments taxable.
Tax Implications for Workers’ Compensation
If you’re getting payments that come from settlement of a workplace incident that’s not a workers’ compensation case, meaning it doesn’t involve physical injury or illness, you will likely have to pay taxes if you sell the payments.
Tax Implications for Inherited Annuities
Many annuity owners designate family members or loved ones to continue receiving payments after they die. The tax liability in this case depends mainly on how the annuity itself is structured.
In some cases, premiums may have already been taxed, which means the beneficiary would only pay taxes on any earned interest.
However, it’s best to contact the annuity company to get a complete understanding of the tax burden connected with your particular annuity when it is passed along as an inheritance.
Tax Implications for Annuity Transfers
Annuity owners who want to transfer ownership to someone else, such as another family member or trusted friend, will be subject to income taxes on anything earned by the annuity at the time of the transfer. The only exceptions are when ownership is transferred to a current spouse, or a former spouse in a divorce settlement.
There may also be federal gift taxes that apply in transfers, and the 2018 rate is 40 percent. But transferring an annuity worth less than $15,000 would not be subject to any taxes since that’s the 2018 exclusion rate.
Tax Implications for Gains
While annuity owners can sell their rights to future payments on most types of annuities, with the exception of those held in IRA accounts or life-only “immediate annuities,” they will have to pay taxes on any gains.
Selling a tax-deferred contract that you bought (meaning that it was not part of a court-ordered settlement) means incurring federal tax liabilities for any earnings along with an additional 10 percent penalty if you’re under the age of 59 years and six months.
Structured Settlements and Deductible Losses
The IRS does not consider a decrease in annuity value to be a loss of income. This means an owner cannot take a deduction on any short-term account reductions that happen because of market decline, as in the case of the annuity’s value falling from one year to the next. As a result, a loss can’t be used to offset any other capital gains or as a carry-over on any capital losses.
For example, if the owner of a nonqualified structured settlement originally has $250,000 in a contract and receives $200,000 as a lump-sum distribution, they may be able to claim a $50,000 loss on their income taxes.
But a nonqualified annuity loss is treated as a miscellaneous deduction for tax purposes. This means it is subject to the 2 percent adjusted gross income threshold, which could limit the amount of losses eligible for deduction.
To figure out how much of a loss would be deductible, calculate 2 percent of your adjusted gross income and then subtract that from the total loss on your annuity. As a general rule, there are three particular circumstances that will allow you to use the decreased value or your annuity to offset ordinary income:
- You surrender an annuity that has lost value.
- You sell an annuity that has lost value to an annuity buyer at a discounted rate.
- You sell immediate annuity premiums to an annuity buyer at a discounted rate.
As with anything involving tax laws and the IRS, the rules can sometimes be confusing. To avoid any problems, consult a tax professional before you make any decisions.
- Internal Revenue Service. (n.d.). 26 CFR 602.602: Tax forms and instructions. Retrieved https://www.irs.gov/pub/irs-drop/rp-17-58.pdf
- Ebeling, A. (2017, October 19). IRS Announces 2018 Estate And Gift Tax Limits: $11.2 Million Per Couple. Retrieved https://www.forbes.com/sites/ashleaebeling/2017/10/19/irs-announces-2018-estate-and-gift-tax-limits-11-2-million-per-couple/#4022e9484a4b
- Internal Revenue Service. (2014, January 13). Sale of Property. Retrieved from http://www.irs.gov/publications/p17/ch14.html When selling payments from a deferred or single premium annuity, the annuity owner is responsible for income tax on distribution earnings.
- Wood, R. (2010, October 26). What's A "Structured Settlement?" Forbes.
- The National Structured Settlements Trade Association. (n.d.). Structured Settlements and Qualified Assignments: How Federal Tax Rules Benefit all Parties in a Claim. Retrieved May 9, 2013, from http://teamarcadia.com/wp-content/uploads/2013/09/NSSTA-StructuredSettlementsAndQualifiedAssignments.pdf