What is a Keogh Plan?
In today's world, more and more Americans are self-employed. Planning for your retirement
becomes increasingly difficult without a structured company plan to guide you. If you see yourself
in this situation someday, a Keogh plan is for you. A Keogh plan is a self-employment retirement
plan. Keoghs offer many tax advantages for employers, but should be considered carefully before
plunging in fully. There are tax deductions and tax-free income that can accumulate from Keogh
plans, but there are many factors to consider. We'll cover some of these.
There are several issues that you must address before investing in a Keogh. You must be aware that
you have to include your employees in the Keogh. These contributions, however, are deductible and
can go towards reducing the cost of your overall contribution. You must also be aware as to
whether or not there will be the availability of cash to regularly contribute to your Keogh plan.
Lastly, you have to know that you cannot withdraw money out of a Keogh until age 59½ without
penalty (with the exception of disability), just like an IRA.
Am I Eligible for a Keogh?
If you have earned self-employment income through your performance of personal services, you are
eligible to set up a Keogh. As far as these types of accounts are concerned, your net profit income is
considered (gross income minus deductions). Income earned overseas is not considered self-
employment income. If you are an inactive owner in a business (i.e. limited partner or retired
partner) you cannot contribute to a Keogh plan.
If you own more than one business, you must set up Keogh plans for all of them. These plans can be
incorporated into one, or remain separate, but it is not permissible for a person to contribute to a
Keogh for one business and not another. If you have both self-employment income as well as
employment income, you can have a Keogh plan. Being an employee and self-employed does not
preclude the opportunity to set up a Keogh.
Defined-benefit Keogh Plans
Defined-benefit Keoghs provide for a specific retirement benefit fund by contributions on an IRS
formula and actuarial assumption. This type of plan allows you to build up retirement benefits
equal to a percentage of your earnings. Defined-benefit plans are very similar to other corporate
plans. This type of plan may prove to be more costly if you have older employees, because this type
of plan requires that you contribute to their plans even if you do not have profits.
In such plans, the maximum annual retirement benefit was not allowed to exceed $98,064 in 1989.
This number has since been adjusted by an inflationary factor. This number, arrived at by the IRS,
assumes retirement at age 65. It must be adjusted for retirement before or after this age.
Defined-contribution Keogh Plans
Under this type of plan, the retirement benefits will depend on the contributions made to your
account and the accounts of your employees over the years that the plan was in effect. If the
contributions were geared towards profits, then the plan is a profit-sharing plan. If they were not
based on the profits, then the plan is a money-purchase pension plan. A plan that is set up so that
contributions to employees' accounts are based on a percentage of their pay would be a money-
purchase pension plan. This sort of plan would require you to make contributions even in years with
no profit, just like a defined-benefit Keogh plan.
There are some limitations on defined-contribution plans. For one, the maximum that one can
contribute to such a plan is the lower between 25% of earned income or $30,000. Because net
earnings must be reduced by the deductible contribution, the maximum contribution for money-
sharing pension plans is reduced from 25 to 20% of net earnings. You are allowed to deduct the
entire 20%. However, with a profit-sharing plan, you cannot claim this 20% deduction. The
maximum deduction for a profit-sharing plan comes out to be 13.0435% of net earnings. Be
especially careful about the deductions you take on profit-sharing defined-contribution Keoghs,
because there is a 10% penalty for exceeding the maximum amount. It sounds crazy, and it is!
The Right Time for Annual Contributions
Like IRAs, a Keogh plan must be established by the end of the year but contributions can
be made at any time up until April 15 of the next year. Also like IRAs, it is advantageous to
contribute as early in the year as possible to let earnings accumulate tax free, but there are other
things to take into consideration. You may be forced to wait until the end of the year to make your
contributions because, by that time, you will know your earnings, and the compensation of your
When You Receive the Retirement Benefits of Keogh Plans
The rules governing Keoghs are very similar to IRAs. If you own more than 5% of your business,
Keogh plan distributions must begin by April 1 following the year in which you reach age 70 1/2.
The penalty for insufficient distributions is hefty. From 1989 onwards, the penalty is 50% of the
difference between the amount you received and the amount required. Your employees are subject
to the same rules. These penalties can add up quickly, so you have to be careful to withdraw the
right amount at the right time!
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