Self Employed

Keogh Plans

Self-employed individuals have different rules and products for retirement saving.

What if you’re self-employed and you want to place some of your earnings in a tax-deferred retirement account, but you don’t want to limit your contribution to $4,000 in an IRA in 2007. You’d like to save considerably more. Do you have the same opportunity available to you as employees who are covered by corporate retirement plans? The answer is yes.

Keoghs allow unincorporated, self-employed business owners (sole proprietors and partnerships) to make tax-deductible contributions and receive the same tax advantages as corporations. Unlike IRAs, Keoghs are still tax-deductible if you’re covered by an employer plan. Suppose you work as a part-time freelance writer in addition to your regular, full-time job. You can use your freelance writer income to open a Keogh. A Keogh plan lets you accumulate savings in a private retirement plan that supplements your pension and Social Security.

Opening a Keogh is a bit more complicated than opening an IRA. You must have a plan document which is approved by the IRS. The plan document describes the type of Keogh plan it is and how contributions are determined. You can have either a defined-benefit or defined-contribution (money purchase or profit-sharing) plan. Your maximum contributions will depend upon the type of plan you establish.

CAUTION: If you are covered by a qualified employer retirement plan, the total annual contributions to defined contribution plans in 2007 cannot exceed 100% of your compensation or $45,000, whichever is less. If you also have a defined benefit plan, a separate limitation applies ($180,000 in 2007).

Can You Have Both A Keogh Plan And An IRA?

Keogh plans can be established in addition to IRA accounts, but since a Keogh plan is a qualified plan, your contributions to your IRA account may not be fully deductible. Additionally, if you work as an employee and participate in the employer’s qualified plan, you can still have a Keogh plan if you have net earnings from self-employment. Your contributions are subject to the overall limitations for defined contribution plans and defined benefit plans.

Caution: Keogh plans must be set up by the end of the year to claim a tax deduction for contributions for that year. But you have until the due date of your tax return (including extensions) to actually make your contribution.

How Keogh Plans Work

If you are self-employed, you can establish a Keogh (a qualified retirement plan) with contributions based on net earnings from self-employment. Contributions to Keogh plans are tax-deductible. The amount of the contribution depends on the type of plan you set up - either defined-contribution or defined-benefit. No matter what type of plan you select, you must fund the Keogh of your eligible employees, that is, you must make contributions to the Keogh plan for your eligible employees. For the employee eligibility rules, see the section Establishing A Keogh Plan. An overview of Keogh plan rules follows.

Defined-Contribution Plans

Defined-contribution plans are the most common type of Keogh plan, and include money-purchase pension plans, and profit-sharing plans. There are overall contribution and deduction limitations to a Keogh plan.

For both types of plans, contributions in 2007 are generally limited to the lesser of $45,000 or 25% of your self-employment income, after the retirement contribution is subtracted.

As the self-employed owner, you may be able to deduct up to 25% of the combined compensation of all eligible employees.

The contribution and the deduction for the contribution to your own Keogh is computed after you subtract your retirement plan contribution from your net earnings. This means that you can’t actually put 25% of your self-employment income into your retirement plan. Effectively, you can put only 20% of your self-employment income into your plan. For example, if your self-employed income is $30,000 (net of 1/2 of the self-employment tax), you can contribute $6,000 ($30,000 - $6,000 = $24,000 x 25% = $6,000; or $30,000 x 20% = $6,000) to your retirement plan.

Defined Benefit Plans

A defined benefit plan provides individuals with specified benefits at retirement, typically in the form of a monthly retirement benefit and typically based on levels of compensation and years of service. If you set up a defined benefit plan, you will need an actuary to calculate the amount necessary to fund the plan.

General Types of Keogh Plans*

Type

Maximum Contribution****

Factors to Consider

Money-Purchase

$45,000 or 25 % of the earned income** from the business, whichever is less.

Contributions are required. You are locked into a specified percentage each year.

Profit-Sharing

$45,000 or 25% of the earned income** from the business, whichever is less.

Your contributions are flexible, up to the maximum percentage you initially set.

Defined Benefit

The plan funds for a fixed annual income at retirement.***

Allows older workers to put away substantially more money, but younger workers may not be able to put away as much as in a money-purchase or profit-sharing plan. Also, there are higher administrative costs with a defined benefit plan.

* Assumes you are an owner-employer

** Your earned income equals your income less the retirement contribution and less 1/2 of the self-employment tax.

*** The maximum defined-benefit you can fund is set annually by the IRS.

**** The employer must make a contribution to each eligible employee’s account. This contribution is not currently taxable to the employee, but is taxed upon withdrawal.

HOT TIP: Your Keogh contributions are deductible on your individual income tax return. Deduct the contributions for your employees on Schedule C (or Schedule F if applicable) on your Form 1040. Take the deduction for contributions for yourself on page 1 of Form 1040 under the section Adjusted Gross Income.

Defined Contribution Or Defined Benefit?

Factors you need to consider when selecting the right type of Keogh include: how much money you need to accumulate; your age; your cash flow, that is, whether you can put money into the plan every year (for employees too); and, the administrative cost of the different plans.

A defined benefit plan is attractive to older self-employed individuals who are just starting a plan because it allows greater contributions for older plan participants. Keep in mind, you will need an actuary to calculate the amount necessary to contribute to the plan. The cost of continuing professional assistance must be factored into the decision. Also, you must make quarterly installments of required contributions.

Generally, if you are young, a defined contribution plan allows you to make a greater contribution to your Keogh plan than does a defined benefit plan. Of the defined contribution plans, a money purchase pension plan requires you to contribute (contributions must be made for you and your employees) to the plan each and every year, regardless of how good or bad your business is doing. So, you need to have sufficient cash flow to support the contributions each year.

On the other hand, a profit-sharing plan is more flexible. Contributions can be any amount up to 25% of the total payroll of plan participants. Plan contributions can be omitted entirely in a bad year. But, the IRS does require that contributions be "substantial and recurring" so the plan is not terminated.

Establishing A Keogh Plan

If you are self-employed, you can establish a Keogh plan for yourself. If you have employees, you must make contributions to the plan for them if they meet the minimum participation requirements (or the requirements of your plan, if more lenient). As the employer, you are responsible for establishing and maintaining the plan.

Written Plan Requirement

A written plan instrument is required for a qualified Keogh plan. All provisions of the plan must be expressly stated in the document. Most plans follow a standard master or prototype plan already approved by the IRS. You can adopt such a plan as offered at most financial institutions, including banks, insurance companies, and mutual fund companies. An individually designed plan can also be established, but IRS approval will be required.

Minimum Participation Requirements

An employee must be allowed to participate in your plan if he or she:

Has reached age 21; and,Has at least 1 year of service (2 years if the plan provides that the employee has a fully vested nonforfeitable right to all of his or her accrued benefit after not more than 2 years of service).

Where To Set Up A Keogh

Banks, mutual fund companies, insurance companies, and brokerage firms all have prototype plan documents which can easily be completed. A trustee must generally be designated and holds title to plan assets, and is responsible for managing them unless this responsibility has been delegated to an investment manager. Where you decide to go should be based on the type of investments you want.

See Investment Considerations For Your IRA for investment concepts relating to your retirement plans. The same concepts apply to Keoghs. If you're going to invest in mutual funds, then go to your broker, investment representative, or mutual fund company. If you're going to put your money in CDs, open an account at your local financial institution. If you prefer annuities, speak with your insurance representative, or broker. Keep in mind that if you buy annuities or certificates of deposit from an insurance company, the Keogh does not need a trustee.

Tax Reporting Requirements

An annual filing must be made with the IRS for Keogh plans. The annual report for a plan is generally made on a Form 5500 (Annual Return/Report of Employee Benefit Plan). Reports are generally due on or before July 31.

HOT TIP: If your Keogh plan covers only you, or you and your spouse if you jointly own a business, you can file Form 5500-EZ, Annual Return of One Participant (Owners and Their Spouses) Retirement Plan.