Overview

A structured settlement pays your damages over time through a tax-free annuity. This guide covers when they make sense, how they work, and the tax advantages.

Key takeaway
A structured settlement pays personal injury damages over time through a tax-free annuity under IRC section 104(a)(2). Payments can be customized to include immediate cash, monthly income, and future lump sums. They are especially valuable for large settlements, minors, and cases with ongoing medical needs.

What Is a Structured Settlement?

A structured settlement is a settlement in which part or all of the recovery is paid through a series of periodic payments rather than a single lump sum. The payments are funded by an annuity purchased by the defendant (or the defendant's insurer) and issued by a highly rated life insurance company.

Legal Framework

  • IRC 104(a)(2): Excludes from gross income damages received on account of personal physical injuries or physical sickness
  • IRC 130: Allows qualified assignments of periodic payment obligations
  • IRC 5891: Imposes a 40% excise tax on factored (sold) structured settlement payments
  • California Insurance Code 10139-10139.5: Regulates transfers of structured settlement payment rights (the Structured Settlement Protection Act)
  • 26 U.S.C. 468B: Qualified settlement funds
The fundamental tax advantage of a structured settlement is this: under IRC 104(a)(2), both the principal and the investment return (interest/growth) within the annuity are completely income-tax-free to the plaintiff. By contrast, if the plaintiff receives a lump sum and invests it, the investment returns are taxable. This difference can be worth hundreds of thousands of dollars over a lifetime.

Tax Advantages of Structured Settlements

The IRC 104(a)(2) Exclusion

Section 104(a)(2) of the Internal Revenue Code excludes from gross income "the amount of any damages (other than punitive damages) received ... on account of personal physical injuries or physical sickness."

Key principles:
  • The exclusion applies to both lump-sum and periodic payments
  • For structured settlements, the exclusion covers both the original investment and all growth/interest earned within the annuity
  • This is the critical advantage: investment growth is tax-free inside a structured settlement but taxable if invested independently

Comparison: Lump Sum vs. Structured Settlement

FactorLump SumStructured Settlement
Initial paymentTaxed only if not for physical injuryTax-free (IRC 104(a)(2))
Investment growthTaxable as ordinary income or capital gainsTax-free
Control over fundsFull controlLimited to scheduled payments
Risk of dissipationHighLow
Creditor protectionLimited (varies by asset)Generally protected from creditors
Inflation adjustmentDepends on investment choicesCan build in COLA increases
Guarantee of paymentDepends on investment performanceGuaranteed by life insurance company
Tax Savings Illustration
A 35-year-old plaintiff receives $500,000. If invested as a lump sum at 5% annual return with a 25% tax rate, after 30 years the after-tax accumulation is approximately $1.58 million. The same $500,000 used to purchase a structured settlement annuity at an equivalent rate grows to approximately $2.16 million tax-free -- a difference of roughly $580,000 attributable entirely to the tax advantage.

What Qualifies for Tax-Free Treatment

Damage TypeIRC 104(a)(2) Exclusion?
Compensatory damages for physical injuryYes
Pain and suffering from physical injuryYes
Medical expensesYes
Lost wages from physical injuryYes
Emotional distress from physical injuryYes
Emotional distress without physical injuryNo (taxable)
Punitive damagesNo (taxable)
Interest/prejudgment interestNo (taxable)
Attorney fees (physical injury case)Not separately taxable (part of excluded recovery)
Non-Physical Injury Claims
If any portion of the settlement is attributable to claims not arising from physical injury (e.g., standalone emotional distress, defamation, employment discrimination), that portion is taxable and does not benefit from the structured settlement tax exclusion. Structure only the physical-injury portion of a mixed-claim settlement.

How Structured Settlements Work

The Qualified Assignment

Process flow

See the interactive flowchart on this page.

  1. The defendant (or defendant's insurer) agrees to fund periodic payments as part of the settlement
  2. The defendant assigns the periodic payment obligation to a qualified assignee (an assignment company) under IRC 130
  3. The qualified assignee uses the funds to purchase an annuity contract from a highly rated life insurance company
  4. The life insurance company makes periodic payments directly to the plaintiff according to the agreed schedule
  5. The defendant is released from further payment obligations
  6. The qualified assignment satisfies IRC 130, preserving the tax exclusion

Key Participants

  • Plaintiff (payee): Receives periodic payments; cannot sell or assign them without court approval
  • Defendant/insurer (obligor): Funds the settlement; obtains release upon funding
  • Assignment company (qualified assignee): Assumes the payment obligation from the defendant
  • Life insurance company (annuity issuer): Issues the annuity and guarantees payments
  • Structured settlement broker/consultant: Designs the payment structure and obtains annuity quotes

Annuity Structure Options

Payment Types

Lump-Sum Payments at Specified Dates

Scheduled lump-sum payments at defined future dates:

  • College fund: $50,000 at ages 18, 19, 20, and 21
  • Home purchase: $100,000 at age 30
  • Retirement supplement: $200,000 at age 65

Monthly/Annual Payments

Regular periodic payments for income replacement:

  • Monthly income: $3,000/month for life
  • Annual payments: $36,000/year for 20 years
  • Increasing payments: $2,000/month increasing 3% annually

Life-Contingent Payments

Payments continue for the plaintiff's lifetime:

  • Life only: Payments stop at death (highest periodic payment amount)
  • Life with period certain: Payments continue for life OR a guaranteed minimum period (e.g., life with 20 years certain)
  • Joint and survivor: Payments continue through the lives of two persons (less common in PI)

Period-Certain Payments

Guaranteed payments for a fixed number of years, regardless of whether the plaintiff survives:

  • 10-year certain: Payments for exactly 10 years
  • 20-year certain: Payments for exactly 20 years
  • If the plaintiff dies before the period ends, remaining payments go to the designated beneficiary

Cost-of-Living Adjustments (COLA)

Structured settlements can include built-in increases to protect against inflation:

  • Fixed percentage increase: Payments increase by a set percentage annually (e.g., 3%/year)
  • CPI-indexed: Payments adjust based on the Consumer Price Index (less common, more expensive)
  • Step increases: Payments increase at defined intervals (e.g., increase by $500/month every 5 years)
Always include a COLA provision in long-term structures. A $3,000/month payment that seems adequate today will have significantly reduced purchasing power in 20 years. Even a modest 2-3% annual increase substantially protects the client's future purchasing power. The cost of adding a COLA is relatively small compared to the long-term benefit.

Common Structures by Injury Type

Catastrophic Injury (TBI, Spinal Cord Injury, Severe Burns)

  • Large initial cash payment for immediate needs (home modifications, vehicle adaptations, medical equipment)
  • Monthly life-contingent payments with COLA for ongoing living expenses and care
  • Period-certain guarantee of at least 20-30 years to protect beneficiaries
  • Separate Medicare Set-Aside funding (if applicable)
  • Lump sums at future dates for anticipated major expenses

Moderate Injury (Orthopedic, Multiple Surgeries)

  • Moderate initial cash payment
  • Monthly payments for 10-20 years covering anticipated treatment costs
  • Lump sums timed to anticipated future surgeries
  • Smaller life-contingent component for supplemental income

Minor's Settlement

  • Deferred lump sum at age 18 (or later, such as 21 or 25)
  • College funding: annual payments at ages 18-22
  • Monthly income beginning at age 25 for financial stability
  • Lump sum at age 30 for home purchase
  • Life-contingent monthly payments beginning at age 30 or 35

Wrongful Death

  • Immediate cash for funeral expenses and transitional needs
  • Monthly income replacement for surviving spouse (life-contingent)
  • Education funding for surviving children (deferred lump sums)
  • Period-certain guarantee to protect minor beneficiaries
Tailor the Structure to the Client's Life
The best structured settlements are designed around the specific client's needs, not off-the-shelf templates. Interview the client (and family members when appropriate) about their anticipated future needs: housing, education, medical care, retirement, and personal goals. A well-designed structure addresses each of these needs with appropriately timed payments.
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Selecting a Structured Settlement Broker

The Broker's Role

A structured settlement broker (also called a consultant) designs the payment structure and obtains competitive annuity quotes from multiple life insurance companies. The broker is typically compensated by a commission paid by the annuity issuer -- the plaintiff does not pay out of pocket.

Selection Criteria

  • [ ] Experience in personal injury structured settlements (not just workers' compensation)
  • [ ] Relationships with multiple highly rated life insurance companies
  • [ ] Willingness to work collaboratively with plaintiff's counsel on structure design
  • [ ] Transparency about commission arrangements
  • [ ] Ability to explain complex annuity concepts in plain language to clients
  • [ ] Track record of reliable service (ask for references)

Annuity Issuer Ratings

Only purchase annuities from highly rated life insurance companies:

Rating AgencyMinimum Acceptable Rating
A.M. BestA (Excellent) or higher
Standard & Poor'sAA- or higher
Moody'sAa3 or higher
FitchAA- or higher
Issuer Financial Strength Matters
The annuity issuer's financial strength rating is critical because the plaintiff depends on the issuer's ability to make payments for decades. If the issuer becomes insolvent, the plaintiff may lose future payments (though state guaranty associations provide some protection, typically up to $250,000-$500,000 depending on the state). Always verify current ratings and diversify among multiple issuers for large structures.

Medicare Set-Asides and Structured Settlements

Funding an MSA Through a Structure

A Medicare Set-Aside (MSA) can be funded through a structured settlement annuity, providing several advantages:

  • Annual MSA funding payments spread the obligation over time
  • Tax-free growth within the annuity reduces the total cost of the MSA
  • Professional MSA administration ensures compliance

MSA Structure Design

Process flow

See the interactive flowchart on this page.

  • Seed amount: Initial lump sum deposited into the MSA account (typically covers 1-2 years of expected Medicare-covered treatment)
  • Annual funding: Annuity payments deposited into the MSA account each year
  • Administration: Professional administrator tracks expenditures and reports to CMS
When an MSA is required, funding it through a structured settlement annuity almost always costs less than a lump-sum MSA because the annuity's tax-free growth reduces the total present-value cost. A $200,000 lump-sum MSA might be replaced by a structure costing $120,000-$150,000 in present value. Always obtain a structured MSA quote alongside the lump-sum calculation.

Minors' Structured Settlements

Structured settlements are particularly well-suited for minor claimants. Courts routinely approve structures as part of minor's compromise petitions under CCP 372 and Probate Code 3500.

Advantages for Minors

  • Protection from dissipation: Funds cannot be accessed by parents or guardians prematurely
  • Tax-free growth: Investment returns accumulate tax-free until payment
  • Guaranteed payments: No risk of poor investment decisions
  • Court-approved: Judges strongly favor structures for minors' settlements
  • Flexibility: Payments can be timed to educational and life milestones

Typical Minor's Structure

  • [ ] Initial cash payment for current medical needs and costs
  • [ ] Deferred lump sum at age 18 (modest amount for transition to adulthood)
  • [ ] Annual payments at ages 18-22 for college/vocational training
  • [ ] Lump sum at age 25 for establishing independence
  • [ ] Monthly income beginning at age 25 or 30 (life-contingent with period certain)
  • [ ] Lump sum at age 30-35 for home purchase

Court Approval Process

When presenting a structured settlement as part of a minor's compromise:

  • [ ] Include the full annuity quote with the petition
  • [ ] Describe each payment component and its purpose
  • [ ] Show the total guaranteed value of the structure vs. the present cost
  • [ ] Identify the annuity issuer and its financial ratings
  • [ ] Explain the tax advantages to the court
  • [ ] Include the assignment company information

See Settlement Agreements for the complete minor's compromise process.

Practical Considerations

Client Counseling on Structured Settlements

When recommending a structured settlement:

  1. Explain the tax advantage in concrete terms (show dollar comparisons)
  2. Emphasize the guarantee -- payments are backed by a life insurance company, not market performance
  3. Discuss the trade-off: Less control over funds in exchange for guaranteed tax-free growth
  4. Address the liquidity concern: The client cannot access structured funds ahead of schedule (except by selling payments at a steep discount under California Insurance Code 10139.5)
  5. Involve a financial advisor: For larger settlements, recommend the client consult a financial advisor who understands structured settlements

When Structured Settlements Make Sense

  • [ ] Client has a long life expectancy (more time for tax-free growth)
  • [ ] Client needs income replacement over many years
  • [ ] Client is a minor or has diminished capacity
  • [ ] Client has a history of poor financial management
  • [ ] Settlement is large enough that tax savings are meaningful ($100K+)
  • [ ] Client is or may become a Medicare beneficiary (MSA funding)
  • [ ] Client wants guaranteed, predictable income

When Lump Sum Is Preferable

  • [ ] Client has immediate, large expenses (home modification, vehicle purchase)
  • [ ] Client is financially sophisticated and can invest effectively
  • [ ] Settlement is relatively small (structure costs may not be justified)
  • [ ] Client has a significantly shortened life expectancy (life-contingent payments lose value)
  • [ ] Client has significant debts that must be resolved immediately
  • [ ] Client needs to fund a business or make a time-sensitive investment

Hybrid Approach: Cash Plus Structure

The most common approach combines a cash lump sum with a structured component:

  • Cash portion: Covers attorney fees, costs, liens, immediate expenses, and an emergency fund
  • Structured portion: Provides long-term income, future lump sums, and tax-free growth
The 'Right' Split
There is no universal formula for the cash-to-structure ratio. It depends entirely on the client's individual circumstances. As a starting point, ensure the cash portion covers: (1) attorney fees and costs, (2) all liens, (3) immediate medical and living expenses, and (4) a reasonable emergency reserve (3-6 months of expenses). Structure the remainder for long-term financial security.
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Anti-Factoring Protections

The Problem: Structured Settlement Factoring

Factoring companies offer to buy structured settlement payment rights for a lump sum at a steep discount (often 40-60% of present value). This strips the plaintiff of the long-term financial security the structure was designed to provide.

Legal Protections

  • IRC 5891: Imposes a 40% excise tax on discounted transfers of structured settlement payment rights (payable by the factoring company, but the economic burden falls on the payee through reduced offers)
  • California Insurance Code 10139.5: The California Structured Settlement Protection Act requires court approval for any transfer of structured settlement payment rights
  • Court approval requirements: The court must find that the transfer is in the best interest of the payee, considering the payee's age, circumstances, and the terms of the transaction

Protecting Your Client

  • Include anti-assignment language in the settlement agreement
  • Educate the client about the financial losses associated with factoring
  • Recommend the client consult a financial advisor before considering any transfer
  • If the client seeks to sell payments, ensure they obtain independent legal advice

Structured Settlement Tax Reporting

For the Plaintiff

  • Periodic payments received under IRC 104(a)(2) are not reported as income
  • No Form 1099 is issued for qualified periodic payments for personal physical injury
  • The plaintiff does not file any special tax forms to claim the exclusion

For the Defendant/Insurer

  • The defendant or insurer may deduct the full cost of the annuity in the year of purchase
  • The qualified assignee reports the annuity and payment obligations
  • IRC 130 governs the tax treatment of the assignment

Record Keeping

  • [ ] Retain copies of the settlement agreement and qualified assignment indefinitely
  • [ ] Keep the annuity contract in a safe location
  • [ ] Maintain records of all payments received
  • [ ] If audited, the settlement agreement and qualified assignment document the IRC 104(a)(2) exclusion

Cross-References

Cross-References

Common Questions

What is a structured settlement?

A structured settlement pays your damages over time through an annuity instead of a single lump sum. The payments are custom-designed based on your needs and can include immediate cash, monthly payments, lump sums at specific future dates, or any combination. Structured settlements are funded by highly rated insurance companies.

Are structured settlement payments taxable?

No. Under Internal Revenue Code section 104(a)(2), periodic payments from a structured settlement for personal physical injuries are completely tax-free, including the investment returns on the annuity. This is one of the biggest advantages of a structured settlement over a lump sum, which would generate taxable investment income.

When should I consider a structured settlement?

Structured settlements make the most sense for large settlements where you need long-term financial security, cases involving minors or vulnerable adults, situations where the plaintiff may have difficulty managing a large lump sum, and cases with ongoing medical needs that require guaranteed future payments.

Can I change a structured settlement after it is set up?

Generally no. Once a structured settlement is established, the payment schedule is fixed and cannot be changed. This is why it is critical to work with an experienced structured settlement broker and your attorney to design a payment plan that meets your long-term needs before finalizing the agreement.

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Local Resources

  1. Internal Revenue Code § 104(a)(2). Tax exclusion for personal physical injury damages.
  2. 26 CFR § 1.104-1. Treasury regulations on personal injury damage exclusions.
  3. California Insurance Code § 10134. Structured settlement transfer approval requirements.
  4. California Insurance Code § 10139.5. Anti-factoring protections for structured settlements.
  5. Periodic Payment Settlement Act of 1982. Federal framework enabling structured settlements.
  6. 42 U.S.C. § 1395y(b)(2). Medicare Secondary Payer implications for structured settlements.