Understanding the Tax Implications of Selling a Structured Settlement
Taxes- theyre everywhere, and theyre never good news. One of the most commonly asked questions in the world of selling structured settlements is whether or not youll have to pay income tax on the amount you receive if you exchange a structured settlement plan for a lump sum payment. The answer is no. Because structured settlements are not taxable, the results of selling a structured settlement are also not taxable.Those benefits are spelled out in the PPSA, or Periodic Payment Settlement Act, which was passed into law back in 1982 under the authority of President Ronald Reagan. The PPSA was designed to make structured settlements the preferred option for creating a long-term, stable financial vehicle for those dealing with the repercussions and aftershocks of accidents or injuries, as well as their families. The PPSA states that the IRS cannot tax income from a structured settlement.
However, its not as cut and dried as it might seem. There is one way the IRS can get its hands on your money. If you change the terms of the original contract, the proceeds of that agreement can then be taxed. How does that jive with the PPSA? Heres what you need to know.
The Tradeoff
As stated above, the PPSA made it illegal for the IRS to consider any lump sum or periodic payments in settlement of physical injury, physical sickness or wrongful death damages in the calculation of income taxes. That includes any interest or capital gains from those settlements as well. It also applies to local, state and federal income taxes (theyre truly tax-free). However, theres a tradeoff here. In exchange for that tax-exempt status, consumers cannot change, modify or control the payment schedule in question. That means that once the settlement is in place, its in place and you cant change it. If you attempt to change it, you open yourself up to 40% taxation on that amount, as well as on any capital gains and interest from it.Workers Compensation Payments
In 1997, Congress decided to extend the structured settlement mandate to workers compensation cases. This was part of the Taxpayer Relief Act of 1997, and it required the use of structured settlements for any workers compensation cases involving physical injuries in the workplace. However, it also provide the same tax-free benefits to those cases.How Can Selling Be Right?
Now, the information above might have made it seem as though selling a structured settlement is a bad thing. Dont you lose your tax-free status here? Think back to the first lines above no, you do not lose your tax-exempt status unless you change or modify the terms of the annuity agreement. Does selling your structured settlement count as changing those terms? No, actually it doesnt.How does it not count as a change in terms? Simply put, you are not changing the wording of the contract. The payment structure and frequency determined by the judge remains in effect. All you are doing is changing where those payments go. Rather than coming to you, the payments will go to the new purchaser. Instead of regular payments, you will receive a lump sum (or whatever percentage of payments traded in you decide works for your situation).
So, youre keeping the agreement intact, and you still get the benefits of the tax-exempt status of structured settlements.
As a note, if you decide to sell a tax-deferred contract that you purchased on your own (one that is not the result of a court-awarded settlement), you ARE responsible for the taxes. The tax-exempt continuation only applies to court-awarded structured settlements for accidents, injuries, lottery payments and the like.
How Does Inflation Affect Your Payments
Inflation the decreasing value of the dollar is largely inescapable. It has an effect on everything, and eventually takes your moneys inherent value down by a great deal when factored over time. How does inflation apply to your structured settlement payments? Actually, it has a great impact on your investment.Inflation eats away at the value of any investment. As the value of the dollar is reduced, so too is the value of your investment. It does that to your annuity, too.
Heres how it works. You purchase an annuity that will pay you $X per month for the next 10 years. That sounds great. However, the problem is that you arent accounting for inflation in that amount. So, while youll still be received $X per month 10 years from now, that amount will not be worth as much as it is right this second. For instance, 20 years ago, a good car cost somewhere in the vicinity of $12,000. Today, youd be hard pressed to find a decent car anywhere in that neighborhood.
To put it in terms that might strike closer to home, lets say that the cost of a gallon of milk today is $4. In a year, that same gallon of milk costs $4.50. If youre only bringing in $4, then you wont be able to buy the same amount of goods you were previously. Your annuitys value has decreased because of inflation. Now, take that same principle and apply it over the course of an annuitys lifespan and you get an idea of just what can happen to your investment.
How Do You Protect Your Annuity?
Given the inescapable nature of inflation, you might wonder if its even possible to protect your annuity from this threat. There are some ways available. For instance, you might purchase an inflation-adjusted annuity. These step up the payouts you receive by a small percentage every year to account for the rate of inflation. However, you dont get that additional money at no cost. Instead, it comes out of your first few years worth of payments. In other words, the insurance company shaves off the front end of the annuity to tack it on to the back end.Of course, if you truly want to avoid the specter of inflation, you can opt to sell your annuity. This gives you a lump sum payment up front and allows you to bypass at least some of the threat of inflation. As a note, no purchaser will buy your annuity for todays face value. Some amount of inflation is always factored into the purchase to protect the buyer from losing money.
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