by Structured Settlement Watchdog
If you receive a structured settlement illustration from a structured settlement broker or settlement planner bearing a rate of return nosing toward 7%, chances are someone's got an extreme case of "Puffery the Magic Dragon"
In the last six months I've observed fantastical numbers on proposals with my own eyes where such returns have been mischaracterized by such terms as "tax free rate of return" or "Internal Rate of Return" when what may be displayed is a taxable equivalent yield.
What is the Internal Rate of Return (IRR)?
The Internal Rate of Return is a common financial technique used determine an investment's rate of return. The use of the term "internal" indicates that that the calculation disregards external elements, including the risk-free rate, inflation, cost of capital and financial risk. IRR can vary based on the inputs and it is reasonable to assume that each cash flow may have a different IRR.
- Flaws in proposals may include masking a lower IRR on a shorter term cash flow in a series of payment streams by using a composite IRR that blends them all together.
- On lifetime payouts with a certain period, comparing lifetime IRR's with different companies that use different mortality tables.
What is the Taxable Equivalent Yield (TEY)?
The taxable equivalent yield is useful to compare tax-free investments to taxable alternatives. It should be noted that the taxable equivalent yield varies by the inputs.
Here is a link to a chart produced by 4structures.com LLC that may be helpful to structured settlement consumers and attorneys.
Tax Advantages of Structured Settlements | Taxable Equivalent Yield Chart
Every structured settlement consultant has access to quoting software for each of the life insurance companies using structured settlement annuity companies that they are appointed with
- Each software has a built in internal rate of return (IRR) calculator.
- The IRR can be calculated and illustrated for each cash flow and should be illustrated for each cash flow. It also reveals the sweet spot for the carrier. You might discover that a lump sum in 15 years pays a higher IRR than a lump sum in 20 years.
- Each software typically has the ability to show the taxable equivalent yield. Such display requires one to enter a tax bracket
Key takeways/questions
Taxable Equivalent Yield IS NOT a Tax Free Rate of Return. Literally read Taxable Equivalent!
If a minor is scheduled to receive a single lump sum at age 18 (i.e. one and done!), why is it relevant to show a life expectancy of 84 years as has been seen?
If there is a lump sum payable to a minor at age 18 why would you assume a tax bracket of more than 30% on a modest lump sum payment?
There are free online calculators that help you fugure out what the tax might be. If you make $50,000 a year living in California as a single filer, you will be taxed $5,308. Your average tax rate is 8.03% and your marginal tax rate is 12%. This marginal tax rate means that your immediate additional income will be taxed at this rate.
For example, you can use the California Tax Calculator 2024-2025: Estimate Your Taxes - Forbes Advisor, to estimate how much tax you might pay on your taxable income. Your tax is $0 if your income is less than the 2024-2025 standard deduction determined by your filing status and whether you’re age 65 or older and/or blind.
Disclaimer: Calculations are estimates based on tax rates as of Jan. 2025 and data from the Tax Foundation. These rates are subject to change. Check the IRS website for the latest information about income taxes and your state tax website for state-specific information.
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