Keogh plans are retirement plans available to businesses that operate as sole proprietorships, partnerships or LLCs. Keogh plans are very popular with self-employed individuals who want to set up a retirement plan with business advantages.
A popular retirement plan choice for the self–employed is a Keogh plan, but this choice isn't for everyone. You're only eligible to establish a Keogh plan if you own a business or part of a business that is not incorporated. You must be operating as a sole proprietorship, a partnership, or a limited liability company (LLC) to participate in a Keogh. In addition, you must actually perform personal services for the business in order to be eligible.
Keogh plans are more flexible than the other easy choice for retirement plan benefits, simplified employee pensions (SEPs), and they allow you to save more toward your retirement. As a result, they are more often used by high-income business owners than are SEPs. Also, Keoghs can be set up as a defined benefit plans or as a defined contribution plan, whereas SEPs must be defined contribution plans.
Iif you're interested in Keogh plans, you should consult with a financial professional or accountant. The following discussion will help you become more familiar with Keogh plans and the terminology associated with them before you meet with your adviser.
Who can have a Keogh?
The general rule is that if you operate in the form of a sole proprietorship or a partnership, you're considered self-employed and thus eligible to set up a Keogh plan. If your business is incorporated, you're not.
In addition, the following people are also eligible to set up a Keogh:
- Christian Science practitioners
- drivers who distribute meat products, vegetable products, fruit products, bakery products, beverages (except milk), or laundry or dry cleaning services
- traveling salesmen who work for wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar businesses
- home workers
Rules for physicians. A salaried doctor is not considered to be self-employed, even if the "salary" is paid by a corporation owned by the doctor. If, however, the doctor has income from other sources, the doctor could contribute to a Keogh from those other sources.
Dr. Makebetter receives a salary from the local hospital. He also has income from a book he published and from court testimony as an expert witness. Although Dr. Makebetter cannot establish and contribute to a Keogh on the basis of the salary he earned from the hospital, he could do so on the basis of the income he earned from the book and from the court testimony.
Rules for consultants. Generally, consultants who receive fees for their services are considered to be self-employed. The rules, however, are less clear for retirees who receive consulting fees exclusively from their former employers. In fact, the courts are split as to whether such a person is self-employed, with the most recent cases finding that such a person is self-employed. Those courts have based their decision on a belief that a person need only hold himself out as available for work to one person (regardless of who that person is) to be regarded as self-employed.
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.
Keogh prohibited transaction rules
There are rules that prohibit an employer from engaging in certain types of dealings with its retirement plan. The rules are designed to protect the plan participants against depletion of plan assets by the employer. For example, the rules limit an employer's right to borrow money from the plan whenever it wants to. These prohibited transaction rules also apply to Keogh plans.
In fact, the rules that apply to Keogh plans are stricter than those that apply to other types of retirement plans. Basically, your plan can't:
- lend any part of the plan's income or principal to an owner-employee
- pay any compensation to the owner-employee for services rendered to the plan
- acquire any property from an owner-employee or sell any property to an owner-employee
Under provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, plan loans to Subchapter S shareholders, partners in partnerships, and sole proprietors of unincorporated businesses are exempted from the prohibited transaction rules beginning in 2002. Congress hopes that the elimination of the loan restrictions will increase the incentive for owner-employees to establish plans and make it more likely that existing plans will offer a loan feature.
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.)
Choosing and funding a keogh
Keogh plans can be set up through banks, insurance companies, brokerage houses, independent plan administration firms, lawyers, accountants, and any of the firms that typically provide financial services. Most of these firms offer a standard Keogh plan, called a prototype plan, that can be modified to fit your circumstances. Specially customized Keogh plans are also available, but they can be much more expensive than prototype plans.
You should discuss which option might be best for you with your tax advisor or accountant.
The main methods of funding a Keogh are:
- through a trust
- through the direct purchase of an annuity or other insurance contract from an insurance company
- through a special custodial account
- through the purchase of special U.S. government retirement bonds