To protect settlement money, decide how it will be received, taxed, and held before you sign the release: characterize the proceeds correctly in the settlement agreement, clear any medical liens and Medicare claims, and then match the funds to the right structure — a structured annuity, a special needs trust, an irrevocable asset protection trust, a court-blocked account for a minor, or a segregated bank account for shorter-term holding. The right combination depends on the type of claim, whether you receive government benefits, and whether the recipient is a child or an adult with a disability. Choices made after the check clears are almost always worse than choices made before.
Keep the IRS Out of the Settlement
Federal tax law excludes damages received for personal physical injuries or physical sickness from gross income, so the compensatory portion of a settlement from a car accident, a slip-and-fall, or medical malpractice generally comes to you tax-free.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness What controls the tax outcome is how each dollar is characterized in the settlement agreement itself, which is why the language matters and why you want the allocation negotiated before you sign.
Several categories fall outside the exclusion:
- Emotional distress damages are taxable unless the distress originated from a physical injury, though any portion that reimburses out-of-pocket medical care is excluded.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness
- Recoveries for defamation, breach of contract, discrimination, lost wages, or business income are taxable as ordinary income.2Internal Revenue Service. Tax Implications of Settlements and Judgments
- Punitive damages are taxable regardless of whether the claim involved a physical injury, with a narrow exception for wrongful-death cases in states whose statutes provide exclusively for punitive damages.2Internal Revenue Service. Tax Implications of Settlements and Judgments
- Interest earned on settlement funds sitting in a bank account is reported as taxable income, even when the underlying settlement is tax-free.
Defendants and insurers generally have to report settlement payments to the IRS on Form 1099 unless a specific exclusion applies, and attorney fees are reported on separate information returns listing both you and the attorney.2Internal Revenue Service. Tax Implications of Settlements and Judgments You may receive a 1099 for the full settlement, including the share your attorney kept, and you need to account for it on your return.
The Attorney-Fee Trap on Taxable Settlements
The miscellaneous itemized deduction that once let plaintiffs deduct legal fees from a taxable settlement was suspended by the Tax Cuts and Jobs Act in 2018 and has been made permanent. On a taxable breach-of-contract or general employment case, that leaves you owing tax on the full settlement, including the portion paid directly to your lawyer.
One exception matters. Federal law allows an above-the-line deduction for attorney fees and court costs in unlawful discrimination cases — claims under Title VII, the Americans with Disabilities Act, the Age Discrimination in Employment Act, and similar statutes — and in certain whistleblower actions. If your case fits, you can deduct the fees before calculating adjusted gross income, so you are not taxed on money you never received.
Clear Liens and Medicare Before You Protect Anything
Whatever structure you plan to use, it only holds what is left after existing claims against the settlement are paid. Get these identified before the funds are disbursed.
Hospital and Health Insurer Liens
Most states let hospitals place a lien directly on a personal injury settlement to recover the cost of treating the injury. These liens are typically filed with the county clerk and attach to the proceeds automatically once recorded. Employer-sponsored health plans governed by ERISA often have a contractual right to reimbursement from any third-party recovery as well.
Your attorney should identify every outstanding lien before finalizing the settlement. Negotiating amounts down is common; hospitals and insurers frequently accept less than the full billed amount. Ignoring a lien is not an option — the lienholder can pursue the funds or sue after you have already been paid.
Medicare Conditional Payments and Set-Asides
Medicare payments made for injury-related treatment while your case was pending are “conditional.” Federal law makes liability insurance the primary payer, so Medicare expects reimbursement once the case resolves.3Office of the Law Revision Counsel. 42 USC 1395y – Exclusions From Coverage and Medicare as Secondary Payer Failing to reimburse can lead CMS to pursue recovery of up to double the original conditional payment amount.4eCFR. 42 CFR 411.24 – Recovery of Conditional Payments
If you are already a Medicare beneficiary and the settlement includes compensation for future medical care, CMS has a process for a Medicare Set-Aside — a portion of the proceeds held in a separate account to pay for injury-related care Medicare would otherwise cover.5Federal Register. Medicare Program; Medicare Secondary Payer and Future Medicals You spend the set-aside funds on qualifying medical care first; only after they are exhausted does Medicare resume paying for injury-related treatment. Calculating the amount correctly, usually with a set-aside professional, avoids later disputes with CMS.
Take Payments Over Time Instead of a Lump Sum
A structured settlement replaces the lump sum with a series of guaranteed future payments from an annuity funded by the defendant or its insurer, with the payment obligation transferred to a third-party assignment company. Because the money never passes through your hands as a lump sum, investment growth inside the annuity stays tax-free as long as the payments qualify under the personal physical injury exclusion. The payments are fixed and cannot be accelerated, deferred, increased, or decreased by the recipient.6Office of the Law Revision Counsel. 26 USC 130 – Certain Personal Injury Liability Assignments That rigidity is the protection: it prevents rapid depletion and provides predictable income insulated from market swings.
The schedule is locked at the time of settlement and cannot be changed. Factoring firms will offer to buy your future payments for a lump sum at a discount, often a steep one. Every state has a structured settlement protection act requiring a judge to approve any sale and find it is in your best interest, precisely because the discount rates can leave you with far less than the present value of the remaining payments. Before agreeing to sell, look at alternatives such as using the payment stream as collateral or adjusting your budget. The loss from factoring is permanent.
If You Receive SSI or Medicaid, Use a Special Needs Trust
Depositing a settlement into an ordinary bank account can immediately disqualify you from Supplemental Security Income or Medicaid. The SSI resource limit is $2,000 for an individual and $3,000 for a couple.7Social Security Administration. Understanding Supplemental Security Income SSI Resources
A first-party special needs trust holds the funds without them counting against the limit. Federal law exempts the trust from the SSI resource calculation when it holds the assets of a person under age 65 who meets the Social Security definition of disability, is established for that person’s sole benefit, and contains a payback provision giving the state the right to recover Medicaid costs from whatever remains when the beneficiary dies.8Office of the Law Revision Counsel. 42 USC 1396p – Liens, Adjustments and Recoveries, and Transfers of Assets The trust can be established by the individual, a parent, grandparent, legal guardian, or a court.
A trustee manages the account and pays for supplemental needs — therapy, education, phone service, recreation, entertainment, and medical services Medicaid does not cover — without reducing SSI. Payments for food or shelter may be counted as income up to a capped amount set annually by the Social Security Administration, which can modestly reduce the monthly SSI check. Professional trustees charge an annual fee, usually a percentage of the trust’s assets, so build that into your planning.
ABLE Accounts as a Complement
An Achieving a Better Life Experience account is simpler and more flexible for smaller amounts. Starting January 1, 2026, eligibility expands to individuals whose disability began before age 46, up from age 26. The annual contribution limit is $19,000 for 2026, and the first $100,000 in the account is disregarded for SSI resource purposes.9Social Security Administration. Spotlight on Achieving a Better Life Experience (ABLE) Accounts If the balance goes above $100,000 and pushes your countable resources past $2,000, SSI is suspended, not terminated, until you spend back down.
ABLE funds grow tax-free and can pay for qualified disability expenses including housing, transportation, education, health care, and assistive technology. You control the account without a trustee. Because the ceiling is lower than a trust, ABLE accounts work best as a supplement — a spending account funded periodically from a larger special needs trust.
Shield the Money From Future Creditors
An irrevocable asset protection trust puts a legal barrier between your settlement and future creditors. When you transfer money in, you give up personal ownership. An independent trustee manages the assets, and a spendthrift clause prevents you, and by extension your creditors, from pledging or reaching the principal to satisfy debts. If someone later sues you or obtains a judgment, funds inside the trust are generally beyond collection.
The protection depends on the trust being genuinely irrevocable. A court can disregard a trust if you kept too much control or created it to escape a debt you already owed. State laws vary, and the enforceability of the spendthrift clause depends on where the trust is formed.
A traditional irrevocable trust requires you to give up all beneficial interest, meaning you cannot also be a beneficiary. Roughly 20 states now permit self-settled domestic asset protection trusts that let the person who funds the trust remain a beneficiary while still receiving some creditor protection, typically with requirements that the trust be administered in the state where it was formed, that an independent trustee manage the assets, and that a waiting period pass before full protection attaches.
Timing controls whether any of this works. Under state voidable-transfer statutes, a creditor can challenge a transfer made with intent to hinder or defraud, generally within a lookback of four to six years. Federal bankruptcy law imposes a two-year lookback, though a bankruptcy trustee can use state law to reach further back. Moving settlement funds into a trust after you know about a potential claim, or while you are already in financial trouble, creates a serious risk the transfer will be reversed. Fund the trust promptly after receiving the settlement and before new liabilities arise.
If the Settlement Belongs to a Minor
When a settlement is awarded to a minor or someone who lacks legal capacity to manage finances, courts typically require the funds to be deposited into a blocked account at a federally insured bank. A blocked account is controlled entirely by court order; the bank cannot allow deposits or withdrawals without a signed order from a judge. The court retains oversight until the minor reaches the applicable age of majority, then issues a release order ending its supervision.
The legal representative, usually a parent or guardian, files periodic accountings with the court. If money is needed before the minor becomes an adult, the guardian files a formal petition explaining why. Courts apply a strict standard and permit withdrawals only in urgent and unusual circumstances. The policy is to protect the minor’s funds, not to relieve parents of the ordinary obligation to pay for the child’s support and education. Withdrawals for the benefit of parents or other family members are not allowed, and commingling the minor’s money with family funds is prohibited.
Holding Settlement Money in a Bank Account
If you receive a lump sum and plan to keep it in a bank account while you set up a longer-term structure, two things matter. FDIC insurance covers up to $250,000 per depositor, per bank, for each account ownership category.10FDIC. Understanding Deposit Insurance A settlement over $250,000 in a single account at one bank exceeds that coverage. You can raise your protection by splitting funds across multiple banks or using different ownership categories at the same bank, each of which gets separate coverage.
Keep the money in a dedicated account, separate from everyday checking or savings. Commingling settlement money with other funds makes it harder to trace and protect if a creditor later tries to reach it. A separate account also simplifies tax reporting, since you can identify which interest income relates to the settlement. If your settlement is tax-free under the physical injury exclusion, the principal stays tax-free regardless of where you deposit it. The interest it earns does not.