Settlement recoveries arising from compensatory damages for personal physical injuries are income tax free. IRC Section 104(a)(2) states in part:
...gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness.
This income tax-exemption is a much needed break for personal injury victims - most of whom have endured severe injuries followed by years of grueling litigation. Additionally, if the injured party decides to utilize a qualified structured settlement annuity with all or a portion of their settlement recovery, the interest earned on that qualified structured settlement annuity is income tax-exempt as well.
Once the settlement funds are placed into a structured settlement annuity, the annuity earns interest on those funds - currently around 5% annually. This allows the benefit of tax-exempt growth in a guaranteed annuity that can secure needed cash flows for years into the future.
Many structured settlement annuities include payments streams that may outlast the measuring life. This can occur if a period certain is used or where payments are made over a lifetime with a guaranteed minimum number of payments. The guaranteed portion of these future payments, while income tax exempt, is not estate tax exempt. Upon the recipients death, the present value of any remaining payments in a structured settlement annuity are included in the gross estate of the decedent. IRC Section 2039 states in part:
"The gross estate shall include the value of an annuity ... receivable by any beneficiary by reason of surviving the decedent under any form of contract ... , if ... an annuity or other payment was payable to the decedent ... for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death."
This can cause a liquidity problem. Commutation riders arranged at the time of settlement allow for the conversion of guaranteed future payments, providing funds to pay applicable estate taxes.