When you win a lawsuit, you can take your money in a single lump sum or slowly over time as a structured settlement. Learn the pros and cons of each approach.
You may have heard that lottery winners can take their award in a single lump sum, or slowly over time. And you might also have heard that they get taxed much higher when they take their money in a single sum.
Personal injury settlements work similarly, although they do have some differences.
Let me explain the facts:
You Most Likely Won’t Get Taxed
In the majority of cases, any funds you receive from a personal injury settlement are not income and, therefore, not taxed.
However, those lovable individuals at the IRS (yes, sarcasm intended) do have a few exceptions to this. If you like reading tax code, you can learn more at the IRS website.
One such exception is:
- If you deducted any medical expenses in prior years, you must pay taxes on the portions that give you a tax benefit
In addition, punitive damages due to physical injuries or sickness are usually taxable as are funds earmarked as lost wages/earnings. Our firm recommends consulting with a tax professional, however, to determine your potential tax liability on any personal injury settlement or verdict.
Advantages and Risks of Structured Settlements
With structured settlements, you get your payments periodically over time. In most cases, they’re more beneficial because they don’t allow you to spend all the money right away, and they accumulate some interest.
Usually, the defending party’s insurance company funds an annuity. You can expect a return of about 1-3% more than the interest you would get on a CD or money market account. The interest gained is taxable, but the principal sum is not.
Structured settlements are also flexible. Say you need a bunch of money now, slightly less for the next 2-3 years, and even less after that. You can structure your payments so you get the largest payments this year, medium-size payments for the next 2-3, and then smaller payments after that.
Structured settlements don’t come without risks though. For example, once you create the payment structure, you can never change it again for any reason. And it’s not guaranteed to keep up with inflation, unless that was agreed to ahead of time.
Finally, it’s possible that, if the company that holds your annuity fails, your money is lost along with them. However, it’s exceedingly unlikely this happens. For starters, you should keep your money with a big, reputable company highly unlikely to fail. And when companies are on the brink of failure, especially traditionally good ones, they often get bought out by other companies. Many annuities are also government-insured.
Advantages and Risks of Lump Sums
It rarely makes sense to take a lump sum. If you have a dire financial situation that needs fixing right now, it may make sense to take a lump sum.
Otherwise, you should generally stay away from lump sums. For one thing, it’s hard to manage a large influx of money if you haven’t before. For another, it can be tempting to spend on things you don’t really need, which could cause it to run out when you need it.
Unless you absolutely need the money right now, a structured settlement makes sense. Because of interest earned over time, it can give you 2-4 times the total amount of money you would get from a lump sum you manage on your own.