HomeTips + AdviceUnderstanding Your Tax Obligations When Cashing Out a Structured Settlement

Understanding Your Tax Obligations When Cashing Out a Structured Settlement

Structured settlements are a common means of settling legal disputes, and have become a popular alternative to going to court. A structured settlement is a form of payment contract that is used to resolve a situation where one party owes money to another party. Structured settlements are often used in tort claims and lotteries. In a structured settlement, the debtor pays their debt in installments over a set period of time, rather than in a lump sum. Structured settlement payments tend to be flexible with respect to terms of payment.

Long-Term Structured Settlements are Tax-Free and Flexible

Under tax law, structured settlement payees do not own the income source. Structured settlement payments are, therefore, tax-free. If a settlement dictates a sum of $72,000 paid out as $500 per month for 12 years, for example, the recipient keeps the full amount. No tax is paid on the $500 per month. Structured settlements are generally more effective over longer terms and with slower payouts.

In certain circumstances though, it is in a person’s best interest to receive upfront cash for structured settlement payments. Structured settlements can be cashed out at any time. If so desired, that $500 per month for 12 years can be paid out as $72,000 upfront; no waiting around for the full amount. It is also possible to cash out only a portion of the settlement. For instance, it is possible to cash out half of the $72,000 settlement to receive $36,000 upfront, which works out to $500 per month for 6 years (instead of 12 years). However, receiving cash for structured settlement payments has certain effects on the recipient’s tax obligations.

Cashing Out: Income Ownership Affects Income Type and Taxation

If you decide to receive cash for your structured settlement payment, you are essentially selling your rights over the long-term income to a third party corporation (usually for less money than what the total amount is worth). Your debtor becomes their debtor. For a lump sum, you sell ownership of the structured settlement. This changes the form of income you receive from debt payment to a business transaction. As a result, you may have to pay income tax on the lump sum (and any interest it earns) if you choose to cash out your structured settlement payment. In contrast, structured settlement payments and the interest they accrue are tax-free. If you choose to invest your structured settlement cash, your earnings become taxable.

There are a number of factors to consider when making the decision whether or not to receive cash for structured settlement payments. If you choose to cash out, you may be required to pay tax on the lump sum. Before making the decision to cash out, it is in your best interest to speak with a financial advisor about how to get the most out of your settlement.

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