Structured settlements do not earn interest the way a savings account or bond portfolio does. There is no balance sitting somewhere accruing returns each month. Instead, the growth is built into the annuity contract at the moment the settlement is funded: the life insurance company charges a premium that is smaller than the total of all the future payments it has promised to make, and that gap functions as interest. It’s fixed, scheduled, and under most circumstances completely tax-free.
How the Growth Is Built Into the Annuity
When a personal injury or wrongful death case settles, the defendant’s insurer usually does not pay the periodic payments itself. It transfers the payment obligation to a third-party assignment company through what the tax code calls a “qualified assignment.”1Office of the Law Revision Counsel. 26 USC 130 – Certain Personal Injury Liability Assignments The assignment company uses the lump sum it receives to buy an annuity from a life insurance company, and the annuity contract fixes every future payment: the exact dollar amount, the exact date, and the total number of payments.
The growth exists because the annuity costs less upfront than the total of the payments it will make. A settlement calling for $1.5 million in total payments over 30 years might be funded by an annuity purchased today for $900,000. The $600,000 difference is the built-in growth. Nothing accumulates in an account you can view. The insurance company has already committed to the full schedule from day one, and future market swings or interest-rate changes cannot alter it.
That is the core distinction between structured settlement growth and ordinary interest. A bond portfolio fluctuates with market conditions. A structured settlement annuity does not. The payments are locked and cannot be accelerated, deferred, increased, or decreased by the recipient.1Office of the Law Revision Counsel. 26 USC 130 – Certain Personal Injury Liability Assignments You trade flexibility for predictability.
Why the Growth Arrives Tax-Free
The financial advantage of structured settlement growth is not just its predictability. It’s the tax treatment. Under federal tax law, damages received on account of personal physical injuries or physical sickness are excluded from gross income, whether they arrive as a lump sum or as periodic payments.2Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness The exclusion reaches the growth component built into future payments, not only the original settlement figure. You do not report the payments on your federal return, and you owe no federal income tax on any portion of them.
Compare that to accepting the same settlement as a lump sum and investing it. Put $900,000 into a bond portfolio earning 5% a year and you’ll owe federal and state income tax on the returns every year. Depending on your bracket, your after-tax return may drop to 3% or lower. The structured settlement delivers the full built-in growth rate with no annual tax erosion, which over a long payout period can add up to hundreds of thousands of dollars in additional value.
When the Growth Is Taxable
The tax exclusion has limits worth knowing. Emotional distress standing alone is not treated as a physical injury under the tax code.2Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness If your settlement compensates emotional distress arising from a physical injury, it qualifies for the exclusion. If it compensates standalone emotional distress with no underlying physical harm, the growth portion of the payments is taxable.
Punitive damages are always taxable, whatever the underlying case looked like. They are treated as ordinary income rather than compensation for a loss. Any structured payments funded by a punitive component carry a tax bill on both the payments and their growth.
Cost-of-Living Increases
Some structured settlements include an annual increase to help payments keep pace with rising prices. The increase is a fixed percentage written into the annuity contract, commonly 2%, 3%, or 4%. It doesn’t change after the contract is signed.
These escalators aren’t indexed to actual inflation. If inflation runs at 6% and your contract calls for 3% increases, your purchasing power falls. If inflation runs below the contract rate, you come out ahead. Negotiating the escalator into the settlement is the only chance to add one. Once the annuity is purchased, the terms are permanent.
What the Growth Is Worth If You Cash Out
Recipients who want a lump sum can sell some or all of their future payments to a factoring company. The factoring company pays cash now for the right to collect the scheduled payments later, and it buys at a steep discount. A stream with a future value of $100,000 might yield only $65,000 to $75,000 in immediate cash, depending on how far out the payments run and the discount rate applied.
The discount is a real, permanent loss of the built-in growth. You give up tax-free guaranteed income in exchange for a smaller, sometimes taxable lump sum. Federal law requires court approval for any transfer; a judge must find the transfer is in the recipient’s best interest, and the recipient must receive written disclosures showing the effective annual interest rate being charged, the total dollar cost, and itemized fees. Transfers that skip the required court order trigger a federal excise tax equal to 40% of the factoring discount on the company acquiring the payments.3Office of the Law Revision Counsel. 26 USC 5891 – Structured Settlement Factoring Transactions Courts routinely deny petitions where the discount rate is unreasonable or the recipient shows no genuine financial need.
What Happens If the Insurer Fails
Because the entire growth schedule depends on the life insurance company behind the annuity, the credit strength of that company matters. If the insurer becomes insolvent, the primary backstop is the state life and health insurance guaranty association. Nearly every state requires licensed insurers to belong to one, and the association steps in when a member company fails.
Coverage limits vary by state. Most states cover up to $250,000 in present value of annuity benefits per payee.4NOLHGA. FAQs: Product Coverage New York, Washington, Utah, and Connecticut each cover up to $500,000. Arkansas, North Carolina, and Louisiana set the limit at $300,000.5NOLHGA. How You’re Protected If the present value of your structured settlement exceeds the applicable state limit, the excess is at risk in an insolvency. That is why structured settlements are typically funded through highly rated carriers: you may be relying on the same company for three or four decades.