The Keogh plan, named after New York Ex-Congressman Eugene Keogh, is a retirement plan created for self-employed workers and unincorporated small businesses (limited liability companies are eligible to establish a Keogh plan). Even employed workers with self-employment income are allowed to create and contribute to a Keogh plan.
Like other qualified retirement plans, contributions made to a Keogh plan are tax-deductible. Contributions and earnings on your contributions aren’t taxed until you withdraw the money.
Establishing a Keogh Plan
The Keogh must be established via a written plan by the end of the tax year for which it is effective. Financial institutions, insurance companies, and some professional organizations have prototype plans that have already been approved by the IRS. A business can create their own plan and have it approved by the IRS, though IRS approval isn’t necessary. Having a prototype plan from a company may be more beneficial because banks and insurance companies typically update their plans as necessary when tax laws change.
It’s important that a Keogh plan continues to abide by tax law. If the IRS audits the plan and finds that it’s not compliant with the law, previous contributions may be declared non-tax deductible. That could result in a tax bill for previous years.
Though the Keogh plan must be established by the end of the calendar year, contributions can be made up until the tax deadline including the tax extension, if one is filed. For example, a Keogh for 2011 must be established by December 31, but contributions can be made until April 17, 2012.
Defined-Benefit Plan vs. Defined-Contribution Plan
Keogh plan rules must specify which type of plan will be created. There are two basic types of Keogh plans: defined-benefit plans and defined-contribution plans.
With defined-benefit plans, the employer decides the specific benefit employees should receive during retirement and makes annual contributions based on that amount. A calculation must be done to decide how much should be contributed each year. With this type of plan, employers are required to make annual contributions based on the calculation.
A defined-contribution plan allows the employer to determine the exact amount to contribute to employee accounts each year. Employers can choose the profit-sharing plan where have a contribution amount that varies each year. The employer can choose to make a contribution only when the company makes a profit. Any year the employer contributes to his own account, he must also contribute to his employees’ accounts. The Keogh plan must specify a method of calculating employee contributions, e.g. based on years of service, age, or some other factor.
The alternate defined-contribution plan is the money-purchase plan where there’s a fixed contribution amount required each year, even when there is no profit. If the employer doesn’t make the required contribution, there’s a tax penalty. To change the contribution amount, the employer has to amend their Keogh plan.
Contributions are capped at 25% of earned income up to $49,000. These plan contribution limits can change each year, based on IRS guidelines. Earned income is income after business deductions and self-employment tax and is often lower than gross income which is what’s used with many other types of retirement plans.
Though employees do not make their own contributions, they must be allowed to participate in the plan. The employer makes entire contributions on the employee’s behalf.
Penalty-free withdrawals from a Keogh plan can’t be made until the employee reaches age 59 ½. Any withdrawals made before that age are subject to a 10% penalty unless there’s an exception:
- The account owner is suddenly disabled
- Medical expenses exceed 7.5% of the employee’s gross income
- The employee is at least 55 and leaves the company or terminates the business
The IRS requires any employee that owns more than 5% of the company to begin taking required minimum distributions (RMD) starting at age 70 ½. Failure to take withdraw the minimum amount will result in a 50% excess accumulation penalty.