Content of the material
- What a Keogh Plan Is
- Keogh Plan Benefits
- Keogh vs. Solo 401(k)
- Who is eligible?
- Pros and Cons of a Keogh Plan
- Join Us
- What are the rules for a Keogh plan?
- How Doesa Keogh Plan Work?
- Fiduciary requirements
- Bottom Line
- Understanding the Keogh Plan
- Contribution and deduction rules
- Keogh deduction, prohibited transaction, fiduciary and funding rules
- Advantages and Disadvantages of Keogh Plans
What a Keogh Plan Is
Keogh plans were designed as self-employed retirement plans for people who run unincorporated businesses. Establishing a Keogh plan requires self-employment income—W-2 employees must have income from independent business activities to qualify. Keogh plans have been largely replaced by other alternatives since the tax code stopped treating retirement plans differently for sole proprietorships and other companies.
In order to set up a Keogh plan, you have to work with a provider that offers these plans. Most self-employed individuals who use Keogh plans have independent administrators to set up and administer their accounts. This is because administering a Keogh plan is more complicated than other types of accounts and requires filing an annual Form 5500. This can increase not only the time to administer a Keogh, but also the cost relative to other plans.
Keogh plans can be structured as either defined benefit plans that provide a set income in retirement (like pensions) or defined contribution plans (like an IRA). Defined benefit plans use actuaries and tell participants how much to contribute to achieve a certain income in retirement. Using defined contribution plans, participants get to choose their contribution level, but the value of their account at retirement will vary.
Defined benefit Keogh plans have an advantage over defined contribution plans because participants can contribute a larger percent of their income. However, Keogh plan contribution limits are $56,000, but vary by how a plan is structured. Also, whether or not Keogh plans are structured as defined benefit or defined contribution plans, there are typically better Keogh plan alternatives available.
If you want to contribute up to $56,000 to a qualified retirement plan, you may want to consider using a SEP IRA or Solo 401(k), which are much easier to administer than a Keogh plan. You can read more on how SEPs vary from Keoghs in the Keogh vs. SEP IRA section below.
Keogh Plan Benefits
A Keogh is a self-employed retirement plan that allows individuals and small business owners to make up to $56,000 in tax-deferred contributions each year. Their account grows tax-free until they take withdrawals after age 59½. Many IRAs limit contributions to 25 percent of income, but Keogh contribution limits can be higher if established as defined benefit plans.
Tax law used to treat incorporated and unincorporated retirement plan sponsors differently, which created cases where Keogh plans were decidedly better than alternatives. However, because these laws have been changed, Keogh plans are rarely the best option for a self-employed individual or small business owner. In most cases, you can get the same benefits and fewer administrative headaches with other retirement benefit accounts.
“In the past, Keogh plans were defined as a type of profit-sharing plan for unincorporated businesses, and some of the features, such as contribution limits, were a bit different (generally lower) from their counterpart in the corporate world. The only real difference now is that the earned income for the business owner that the profit-sharing contribution is calculated for may need to be adjusted by the amount of the contribution on his behalf.”
– Clifford L. Caplan, CFP, AIF, President, Neponset Valley Financial Partners
Keogh vs. Solo 401(k)
A Solo 401(k) is another great self-employment retirement plan that’s ideal for businesses that have no employees except the owner. Solo 401(k)s are structured very similarly to other 401(k) plans but with fewer administration requirements. However, if you ever hire employees, a Solo 401(k) can be quickly expanded to add new participants.
Solo 401(k)s have the same high contribution limits as Keogh plans and are much easier to administer. Like SEP IRAs, Solo 401(k)s can only be set up as defined contribution plans, but they are much more flexible and cost-effective than Keogh plans.
Another way to compare a Keogh versus Solo 401(k) is to study the investment options and costs of a Solo 401(k) available through several providers. You can also see how the administration requirements of a Solo 401(k) compare to a Keogh. Visit our list of the Best Solo 401(k) Providers for more information.
If you think you may want to set up a Solo 401(k) instead of a Keogh, we recommend that you check out ShareBuilder 401k. ShareBuilder 401k offers very cost-effective 401(k)s, including single-participant plans. Be sure to check out ShareBuilder 401k to see how they can help you with your Solo 401(k).
Who is eligible?
- Self-employed individuals
- Individuals that own an unincorporated business
- Partners of special partnerships who own more than 10% of the partnership, or shareholders who own more than 10% of a corporation of individuals
Pros and Cons of a Keogh Plan
Keogh plans provide a number of benefits for self-employed people. Their contribution limits are higher, meaning more money goes in the account. This could be especially beneficial for older, high income earners. Keogh plans offer small business owners and even some employees tax-favored retirement savings. Small business employers may also deduct the contributions made for their employees.
Keogh plans do pose some problems, though, as fairly complicated financial tools. They often require tax and financial advisors to handle the vast amount of paperwork involved. Hiring a professional is one more step a taxpayer can take to ensure that the numbers and calculations will all come out correctly. Keogh plans also require more upkeep than either Simplified Employee Pension (SEP), simple IRAs or 401(k) plans – which means that these costs can add up. Further, certain plans will require contributions from you each year in order to meet a minimum funding standard. This still applies even if you’re a bit strapped for cash.
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What are the rules for a Keogh plan?
The rules for a Keogh plan are similar to those applicable to many other retirement plans for the self-employed:
- Contributions are tax-deductible up to annual limits
- Money in a Keogh plan can be invested and grow on a tax-deferred basis until retirement
- Withdrawals can be made penalty-free after 59 ½. You are subject to a 10% penalty for early withdrawals unless a hardship exemption applies
- You are required to take retired minimum distributions after age 72
- Ordinary income tax applies to withdrawals
- You can roll over a Keogh plan into a traditional or Roth IRA but may owe taxes on a Roth conversion
How Doesa Keogh Plan Work?
Like a 401(k) or an IRA, a Keogh plan allows you to invest pre-tax money in your retirement account. This means that you can deduct every contribution you make from your taxable income up to a specified limit (defined by your specific plan).
Also like a 401(k) you will pay taxes on this money once you begin to withdraw it, which must happen no sooner than age 59½ and no later than age 70. Withdrawing money earlier than this will trigger early distribution tax penalties of 10% plus all applicable normal income taxes. Not beginning to take money out at age 70 will trigger a tax penalty of 50% of the minimum required withdrawals.
Generally, when you set up a pension plan, the people who manage the pension assets (including you, if applicable) are fiduciaries and are subject to a standard of conduct appropriate to fiduciaries. This means that they may be held legally responsible to plan participants for losses to the plan.
The Department of Labor, however, has taken the position that a plan that covers only self-employed persons, and does not cover any common-law employees, is not subject to the fiduciary standards.
A broker invests the funds in a Keogh account unwisely, and a loss occurs. Because the account was for the sole benefit of a self-employed consultant, the broker is not subject to ERISA’s fiduciary responsibilities and is not liable to the consultant for the losses. (However, the broker could be liable under the other rules, including SEC regulations, that govern the actions of brokers and other investment advisers.)
When searching for the best retirement plans, you’ll have to carefully consider a number of plans, especially if you are self-employed or a small business owner. A Keogh plan may not be the best of the available options when compared to SEP-IRAs, solo 401(k)s or individual 401(k)s. However, when looking at plans, you won’t want to forget that these qualified plan structures exist.
Understanding the Keogh Plan
Keogh plans are retirement plans for self-employed people and unincorporated businesses, such as sole proprietorships and partnerships. If an individual is an independent contractor, they cannot set up and use a Keogh plan for retirement.
The IRS refers to Keogh plans as qualified plans, and they come in two types: defined-contribution plans, which include profit-sharing plans and money purchase plans, and defined-benefit plans, also known as HR(10) plans. Keogh plans can invest in the same set of securities as 401(k)s and IRAs, including stocks, bonds, certificates of deposit (CDs), and annuities.
Contribution and deduction rules
The amount of the contribution you can make to your Keogh plan is determined by the amount of your “earned income” for the year. Earned income is defined as your gross income from a trade or business, less any allowable deductions. Income received by a passive partner is considered to be investment income rather than earned income.
Contribution limits. The limitations on contributions depend on the type of Keogh plan. A Keogh defined benefit plan is limited to the amount needed to eventually produce an annual pension payment of the lesser of:
- $210,000 for 2014 ($205,000 for 2013); or
- 100 percent of your average compensation for your three highest years.
This limit may be adjusted annually for inflation.
A Keogh defined contribution plan contribution is limited to the lesser of $52,000 for 2014 ($51,000 for 2013; this amount may be adjusted annually for inflation) or 100 percent of the participant’s earned income for the year.
Keogh deduction, prohibited transaction, fiduciary and funding rules
The rules for contribution deductions by self-employed individuals are as follows:
- If the self-employed person is a sole proprietor, the person can take the entire deduction on the individual income tax return.
- If the self-employed person is a partner, the partner can take the amount of the contribution made by the partnership on the partner’s behalf.
- A partner, however, cannot deduct contributions made on behalf of his or her common-law employees (since that deduction is taken by the partnership and is ultimately reflected in the partner’s distributable share).
If an owner-employee is engaged in more than one business, but only one business has a Keogh plan, contributions and deductions to that plan on behalf of the owner-employee can be based only on the earned income from the business that has the plan.
Timing for contributions. Both cash-basis and accrual-basis taxpayers may make Keogh contributions after the close of the taxable year if they are made on or before the due date, including extensions, for filing the income tax return for that tax year. You must set up the Keogh by the end of the tax year in order for your contributions made to it to be deductible for that tax year.
If you miss the end-of-the-year deadline for establishing a Keogh plan, you can still establish a simplified employee pension (SEP), as long as you do so by the due date, including extensions, of your income tax return. Establishing a SEP in this way does not mean you can’t establish a Keogh later.
Advantages and Disadvantages of Keogh Plans
Keogh plans were established through legislation by Congress in 1962 and were spearheaded by Rep. Eugene Keogh. As with other qualified retirement accounts, funds can be accessed as early as age 59½, and withdrawals must begin by age 72, or 70½ if you were 70½ before Jan. 1, 2020.
Keogh plans have more administrative burdens and higher upkeep costs than Simplified Employee Pension (SEP) or 401(k) plans, but the contribution limits are higher, making Keogh plans a popular option for many high-income business owners. Because current tax retirement laws do not set apart incorporated and self-employed plan sponsors, the term “Keogh plan” is rarely ever used.