A structured settlement is a legally binding contract in which a person or corporate entity agrees to pay the beneficiary with regular payments, usually over the course of several years. It’s commonly used in cases involving Worker’s Compensation, wrongful death, and personal injury. However, most cases offer the beneficiary of a choice between a structured settlement and lump sum payout. So, which one should you choose?
There’s a greater risk associated with structured settlements when compared to lump sum payouts. If the company responsible for paying the beneficiary declares bankruptcy, the settlement is wiped clean, leaving the beneficiary without any additional payments. The beneficiary may attempt to sue to the company for the remainder of the payment which he or she is owed, but filing bankruptcy in the US typically forgives this type of debt.
This doesn’t necessarily mean that you should avoid structured settlements, but rather you should mitigate your risk by doing your homework before declining a lump sum payout. Find out which company will be holding the money you are owed, and research them online. How long have they been in business? Do they have any open complaints with the Better Business Bureau? Do they have an active website? These are all questions you should try to answer before agreeing on a structured settlement.
Uncle Sam gets enough of your money around April of each year (assuming you file your taxes on due date), so it’s important to minimize your tax responsibilities with payouts. This is where things can get confusing, though, because there are tax breaks associated with both structured settlements and lump sum payouts.
If the structured settlement is an annuity (the most common type of structured settlement), it is generally sold to a life insurance company. The life insurance company may then invest the money into Treasury Securities so it will build interest over time. The great thing about this is that all interest earned on annuity-based investments tied to a structured settlement is tax-free on both the federal and state levels. Depending on the size of the payout, this can yield HUGE tax savings in the form of thousands of dollars over the course of a year. This is one of the main reasons why so many people choose structured settlements over lump sum payouts.
Lump sum payouts are also considered tax-free in the eyes of the government. Regardless of the sum, you shouldn’t have to pay taxes on it. The only time when taxes are incurred on a lump sum payout is when the beneficiary invests it. Unlike an annuity, any interest and dividends earned on lump sum investing is taxable; therefore, you need to be conscious if your money is invested.
While each and every case is different, it’s not uncommon for structured settlements to yield a higher total payout when compared to a lump sum payout. Again, this is due to the fact that many companies that hold structured settlements invest part or all of it into Treasury Securities. If a worker has been granted $150,000 as part of a Worker’s Compensation dispute, he or she can choose the lump sum payout for the full $150,000 up front, or they can accept a structured settlement, which will allow the total payout to grow over time. That $150,000 may snowball into $200,000 or more over the course of several years, and as we mentioned before, the additional $50,000 in interest and dividends remains tax-free (assuming it was paid out through an annuity).
How much self-control do you have over your spending habits? It’s not uncommon for people who receive lump sum payouts to go on wild “spending sprees,” burning through their cash in little-to-no time. Not everyone falls under this category, but poor budgeting, lack of self-control, and a general disassociation with one’s finances can spell disaster for lump sum payouts.
With a structured settlement, however, you don’t have to worry about spending all of your money at once. The company holding the settlement will send you small payments over time, usually on a monthly or bi-weekly basis. Even if you go on a mini spending spree with a monthly payment, you can rest assured knowing that you’ll receive another payment the following month.
Ability to Pay Off Debt
Of course, there are plenty of reasons to choose a lump sum payout over a structured settlement, including the ability to pay off one’s debt. According to NerdWallet.com, the average US household credit card debt is $15,863. Keep in mind that this number only reflects credit card debt, not mortgage, student loans, car loans, personal loans, etc. By accepting a lump sum payout, you can use part of the money to pay off your debt, which subsequently reduces or even eliminates interest charges.