Taxes on legal settlement Tax Talk by George Saenz • Bankrate.com

Dear Tax Talk,
I received a non-allocated monetary settlement in court prior to jury selection on a civil suit. Do I have tax liability as it was non-allocated, i.e., pain and suffering and punitive? The judge left the percentage up to me. -- Tom

Dear Tom,
Just like the judge left it up to you, so does the Internal Revenue Service. Unless, of course, you get audited and they disagree with your allocation. Amounts awarded in a civil suit, or in settlement thereof, for claims of physical injury are not taxable. In 1996, the law was changed from personal injury recoveries being tax-free to only physical injury claims. Physical injury does not include claims of emotional distress unless related to a physical injury or recoveries relating to dignitary claims (such as age discrimination, defamation, etc.). Amounts received that represent a recovery of previously deducted medical expenses would be taxable. Amounts received that are in the nature of punitive damages are taxable.

To make a reasonable allocation, subtract from the settlement all amounts claimed in the original suit as compensation for lost income, pain, suffering, past and future medical expenses, and any other claim not punitive. If the settlement amount is in excess of these amounts, what's left is the portion that should be considered punitive damages. The settlement should be in excess of this; otherwise it does not appear you were awarded punitive damages.

Self-employed retirement limits

Dear Tax Talk,
I am confused on the maximum amount a self-employed individual can claim for a SEP-IRA deduction in 1999. Is it $20,870, $24,000 or $30,000? Sincerely, -- Brandon

Dear Brandon,
Your confusion is understood. There are several available pension plan options for a self-employed person. The deduction limitations and investment options among them vary greatly.

A SEP-IRA is one of the basic plan options and is established similar to an IRA. However, unlike an IRA, a self-employed individual has until the extended due date of his return to make the prior year contribution and the deduction can be as high as $24,000 in 1999. In order to get a deduction of $24,000 the individual's net self-employment income has to be greater than $160,000. Net self-employment income is the net self-employment income reported on Schedule SE, reduced by one-half of the self-employment tax and the deduction for the SEP contribution. The $160,000 base is indexed for inflation annually.

An alternative to SEP-IRA is a Keogh plan. Establishing a Keogh generally requires the assistance of a pension plan adviser or an accountant. The deduction limitations under a Keogh are greater, depending on the type of plan established. A basic Keogh plan, such as a money-purchase plan, can get you a deduction of $30,000.

Another Keogh plan known as a defined benefit plan can get you a higher deduction depending on your age. Under a defined benefit plan, sufficient funds have to be contributed to the plan in order to provide a retirement benefit at retirement age. If the time to retirement is short due to the age of the individual, then the contributions have to be significant. The contributions to a defined benefit plan are not limited to a percentage of income. All Keogh plans are required to be established by the end of the year.

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