Structured settlements are a common method for resolving personal injury claims and other legal disputes. While these arrangements offer many benefits, one question that often arises is whether structured settlements earn interest. This article will explore how interest relates to structured settlements, exploring various aspects of this complex topic. 

Understanding structured settlements 

A structured settlement is a financial arrangement where, instead of receiving a lump sum payment, the recipient (typically the plaintiff in a legal case) agrees to receive a series of periodic payments over time. These payments are usually funded through an annuity purchased by the defendant or their insurance company. 

Structured settlements are commonly used in cases involving: 

• Personal injury claims 
• Workers’ compensation 
• Medical malpractice 
• Wrongful death suits 

The concept of interest in structured settlements 

When asking whether structured settlements earn interest, it’s important to distinguish between two concepts: 

• Growth of the underlying annuity 
• Interest explicitly paid to the settlement recipient 

Let’s explore each of these in detail… 

Growth of the underlying annuity 

In most cases, structured settlements are funded by annuities purchased from life insurance companies. These annuities are financial products designed to provide a stream of payments over time. The insurance company invests the lump sum used to purchase the annuity, and this investment typically grows over time. 

This growth is factored into the payment schedule when the structured settlement is established. In other words, the future payments are calculated based on the expected growth of the annuity. This allows for larger payments in the future compared to what would be possible if the settlement amount was simply divided into equal payments over time. 

However, it’s crucial to understand that from the recipient’s perspective, this growth is not “interest” in the traditional sense. The recipient doesn’t see the growth of the underlying annuity; they simply receive the predetermined payments as scheduled. 

Interest explicitly paid to the recipient 

In some cases, structured settlements may include payments that are explicitly characterized as interest. This is more common in non-qualified structured settlements (those not arising from personal physical injury cases) or in settlements that include both tax-free and taxable components. 

When interest is explicitly included in a structured settlement, it’s typically treated differently for tax purposes than the principal amount of the settlement. 

Tax implications of “interest” in structured settlements 

The tax treatment of structured settlements can be complex, especially when it comes to any component that might be considered interest. 

Qualified structured settlements 

For qualified structured settlements (those arising from personal physical injury or sickness claims), all payments received are generally tax-free under Internal Revenue Code Section 104(a)(2). This includes any growth or “interest” component built into the payment schedule. 

In other words, even though the annuity funding the settlement may be growing over time, the recipient doesn’t pay taxes on this growth. From a practical standpoint, this means the recipient doesn’t need to consider whether their payments include an interest component. 

Non-qualified structured settlements 

For non-qualified structured settlements (such as those arising from employment disputes or property damage claims), the tax treatment is different: 

• The portion of each payment representing the return of principal is tax-free. 
• Any portion representing interest or earnings is taxable as ordinary income.

In these cases, the settlement agreement should specify how much of each payment is considered interest for tax purposes. 

Factors affecting growth in structured settlements 

Several factors can influence the growth or “interest” component of a structured settlement: 

• Current interest rates: The prevailing interest rates at the time the settlement is established affect the growth rate of the underlying annuity.
• Length of the settlement: Longer payment schedules generally allow for more growth over time. 
• Payment structure: The specific payment structure (e.g., level payments, increasing payments, lump sums at certain intervals) can affect how growth is factored into the payments.
• Type of annuity: Different types of annuities (fixed vs. variable) may offer different growth potential. 

Pros and cons of the “interest” aspect of structured settlements 

Advantages: 

• Tax-free growth: In qualified settlements, the growth is effectively tax-free. 
• Guaranteed returns: The growth is typically based on a fixed rate, providing certainty. 
• No management required: Recipients don’t need to manage investments to benefit from growth. 

Disadvantages: 

• Lack of control: Recipients can’t control or directly benefit from the underlying investments. 
• Inflexibility: Once established, the payment schedule usually can’t be changed. 
• Potentially lower returns: The conservative nature of annuities may result in lower growth compared to other investments.