This post was originally published on this site
What is it?
A Keogh plan (sometimes referred to as an HR-10 plan) is simply a qualified retirement plan established by a self-employed individual or a partnership. If you are self-employed or a partner in a partnership, you don’t need to have employees to establish a Keogh plan. If you have employees, though, you generally must allow them to participate in your plan if they meet the minimum participation requirements.
A Keogh plan can be structured as either a defined contribution plan or a defined benefit plan.
Prior to 1983, there were significant differences between Keogh plans and qualified plans for incorporated businesses. Currently, however, aside from specific definitional differences, qualified plans for the self-employed are virtually identical to qualified plans for incorporated businesses.
Who can establish a Keogh plan?
Sole proprietors, partnerships, consultants, and individuals working as independent contractors can establish a Keogh plan. The key eligibility requirement is that you have self-employment income. As long as you meet this requirement, you may set up and contribute to a Keogh plan. This is true even if your self-employment income is supplementing income from a full-time job elsewhere.
For Keogh plan purposes, a self-employed individual is considered both the employer and an employee.
Defined contribution plan vs. defined benefit plan
Keogh defined contribution plan
A Keogh plan can be structured as a defined contribution plan. A defined contribution plan is a qualified retirement plan in which the contribution level is defined, but the eventual benefit to be paid is not. Each participant has an individual account, and the benefit at retirement depends on the amounts contributed and the investment performance of the account. A Keogh defined contribution plan can be structured as a profit-sharing plan, a money purchase pension plan, or a combination of the two.
Keogh defined benefit plan
If you decide not to structure your Keogh as a defined contribution plan, you can structure it as a defined benefit plan. With this type of plan, you contribute as much as necessary in order to reach a predetermined benefit upon retirement. The plan is funded entirely by the employer. An actuary is generally required to review your plan every year to determine what your annual contribution should be, based on the distributions you want, the investment performance of the pension funds, and the plan’s normal retirement age. This type of plan is less frequently used than the defined contribution plan, as it usually is more expensive to maintain.
Keogh plan contributions
Deductible contributions for self-employed individuals — special note
As a self-employed individual, your deductible Keogh plan contribution on your own behalf is tied to your earned income. However, your earned income depends in part on how much of a Keogh contribution you make. Because of this circular relationship, self-employed individuals have to make an adjustment to any defined contribution plan contribution rate when calculating their own contributions to a Keogh plan. The IRS has created a table (provided in IRS Publication 560) listing the self-employed contribution rates for plan contribution rates between 1% and 25%. A self-employed individual calculates net profit from self-employment, and then deducts one-half of self-employment taxes (without regard to any Keogh contributions). The result (“net earnings from self-employment”) is multiplied by the plan contribution rate as adjusted for self-employed individuals to determine the self-employed individual’s deductible Keogh contribution.
Your contribution cannot exceed the annual compensation limit ($345,000 in 2024, up from $330,000 in 2023) multiplied by the unreduced plan contribution rate.
| |
If the Plan Contribution Rate Is: (shown as percent) | Your Contribution Rate Is: (shown as decimal) |
1 | .009901 |
2 | .019608 |
3 | .029126 |
4 | .038462 |
5 | .047619 |
6 | .056604 |
7 | .065421 |
8 | .074074 |
9 | .082569 |
10 | .090909 |
11 | .099099 |
12 | .107143 |
13 | .115044 |
14 | .122807 |
15 | .130435 |
16 | .137931 |
17 | .145299 |
18 | .152542 |
19 | .159664 |
20 | .166667 |
21 | .173554 |
22 | .180328 |
23 | .186992 |
24 | .193548 |
25 | .200000 |
Earned income is net earnings from self-employment. It must be earned from personal services and cannot include unearned income from such sources as dividends and interest.
If you are self-employed, you can make contributions for yourself only if you have net earnings from self-employment in the trade or business for which the plan was established. Consequently, if you have a net loss from self-employment, you cannot make contributions for yourself for the year even if you can contribute for common law employees based on their compensation.
The calculation of a self-employed individual’s deductible Keogh contribution can sometimes be complex, especially if you have employees or if your plan is integrated with Social Security. Your tax advisor should be able to assist you in making these difficult calculations. The IRS also provides worksheets in Publication 560.
Contributions for employees
If you set up a Keogh plan and you have employees, you generally must allow them to participate in the plan. The rules and limits that govern your contributions to your plan are generally the same as for qualified retirement plans established by incorporated businesses. That is, if you establish a Keogh profit-sharing plan, the plan will be subject to the profit-sharing rules regarding contributions. If you establish a Keogh defined benefit plan, contributions to the plan must comply with all defined benefit plan rules.
Limits on contributions
If a Keogh plan is structured as a defined contribution plan, an individual participant can receive no more than the lesser of $69,000 (in 2024, up from $66,000 in 2023) or 100% of the participant’s compensation (50% of a self-employed individual’s net earnings from self-employment). This limit is generally referred to as the Section 415 “annual additions” limit. If your Keogh is structured as a defined benefit plan, the maximum annual benefit payable under the plan is limited to $275,000 (in 2024, up from $265,000 in 2023).
If your Keogh plan is a 401(k) plan, age 50 catch-up contributions (up to $7,500 in 2024) can be made in excess of the $69,000 annual additions limit.
When calculating the annual additions limit, you must aggregate all qualified defined contribution plans you maintain.
A separate limit applies when determining an employer’s maximum tax-deductible contribution to a Keogh plan. In general, an employer can deduct up to 25% of the total compensation of all participants covered under the plan.
If your Keogh plan is a 401(k) plan, employee pre-tax contributions (including your own) are not subject to this 25% deduction limit, and may be deducted in full in addition to any profit-sharing contribution you make to the plan.
For purposes of calculating your maximum tax-deductible contribution, the maximum compensation base that can be used for any one plan participant is $345,000 (for 2024, up from $330,000 in 2023).
For a Keogh defined benefit plan, there is no specified annual contribution limit. Contributions are generally calculated by actuaries as the amounts needed to fund the benefits promised under the plan. The benefits upon which contributions are calculated are subject to limits, however.
If you adopt both defined benefit and defined contribution Keogh plans, an overall deduction limit applies. See IRS Publication 560 for more information.
Advantages of Keogh plans
In general, a Keogh plan offers you and your employees (if any) the same tax benefits as qualified plans for incorporated businesses. The specific advantages of a Keogh plan depend largely on whether the plan is structured as a defined contribution plan or a defined benefit plan. For example, participants are generally permitted to take loans from a defined contribution plan (if the plan allows), but not from a defined benefit plan.
Disadvantages of Keogh plans
In general, a Keogh plan offers the same disadvantages as qualified plans for incorporated businesses. Specific disadvantages depend upon how the Keogh plan is structured (e.g., defined contribution plan or defined benefit plan).
If you’re a self-employed individual with no employees, however, cost and overall administrative complexity — among the more significant disadvantages of qualified plans — are greatly reduced. In general, this is because the Employee Retirement Income Security Act of 1974 (ERISA) does not apply to plans that cover only you, or you and your spouse.
Your Keogh plan assets are fully protected
from your creditors under federal law if you declare
bankruptcy. However, since a plan that covers only you, or you and your spouse, isn’t subject to ERISA, whether your plan’s
assets will be protected from your creditors outside of
bankruptcy will be determined by the laws of your
particular state. Consult a professional if asset protection is important to you.
Tax considerations
The specific tax consequences of a Keogh plan depend on the type of plan (defined contribution or defined benefit). In general, though, the following tax considerations apply:
- Tax-deductible contributions: The Keogh plan contributions you make on behalf of yourself and your employees (if any) are generally tax deductible for federal income tax purposes (subject to limits).
- Tax deferral: Funds in a Keogh plan are tax deferred. You and your employees (if any) do not pay income tax on plan contributions or earnings until you take distributions from the plan. The benefits of tax deferral can be significant, creating the potential for more rapid growth than if the funds were invested in the same investments outside the plan.
- Taxable distributions: When you or an employee takes a distribution from the Keogh plan, the distribution will be subject to federal (and possibly state) income tax for the year in which it is made (less a prorated part of any cost basis). Because most recipients have no cost basis, a distribution is generally fully taxable. [Special rules apply to Roth 401(k) plans.]
If you or an employee elects to take a lump-sum distribution from the Keogh plan, and meets certain requirements (e.g., having been born before 1936), special income averaging treatment may be available to reduce the federal tax rate on the distribution.
- Possible early withdrawal penalty: In addition to income tax, if you or an employee takes a Keogh plan distribution prior to age 59½ (age 55 in certain cases), the distribution will generally be subject to a 10% federal premature distribution tax (and possibly a state penalty tax), unless an exception applies.
- Possible tax credit: If you establish a new Keogh plan and have at least one employee who is not a highly compensated employee (see below for definition), you may be eligible to claim an income tax credit for a portion of your qualified start-up costs to create or maintain the plan in three tax years.
- Possible estate tax: Generally, when you or an employee dies, the full value of the decedent’s interest in the Keogh plan will be included for purposes of determining if any federal estate tax is due.
- Saver’s credit: Some low- and middle-income taxpayers may claim a federal income tax credit (“Saver’s Credit”) for contributing to your Keogh plan.
How to establish a Keogh plan
Use either a plan designed by a financial institution and pre-approved by the IRS, or have a plan designed for you
The easiest and quickest way to establish a Keogh plan generally is to use a plan pre-approved by the IRS, for example a prototype or master plan, or a volume submitter plan, designed by a bank, insurance company, mutual fund, law firm, or other institution. With these plans, the sponsoring institution does most of the paperwork to install the plan at a low or minimal cost to you. In return, you keep most or all of the plan funds invested with that institution.
If you decide that you do not want to use a prototype plan, you can instead hire an attorney or pension consultant to design a plan specifically for your organization. This is usually more expensive than using a plan already pre-approved by the IRS.
Arrange how the plan funds will be invested
You can select from a variety of investments to build your plan’s funds. These may include mutual funds, annuities, individual stocks and bonds, and practically any other investment property.
Set up the plan before the end of the year in which you wish to deduct contributions
If you are a calendar-year taxpayer, you must set up the plan by December 31. In addition, the plan (the specific plan provisions) as well as the trust agreement (if the plan uses a trust) must be in writing and communicated to employees by the year-end date. Simply referring to a requirement of the Internal Revenue Code is insufficient. For your contributions to be deductible in that year, your contributions may be made after the year-end date as long as they are made by the date your tax return (with any extensions) is due, and are identified as being made for that year.
In some states, a trust may not be valid until it is funded. Therefore you may wish to contribute at least a few dollars into the trust by December 31 of the year you establish the plan.
Pat, a calendar-year taxpayer, owns his own barbershop. He is eligible to contribute $15,000 to his Keogh plan. On February 22, 2024, Pat paid $15,000 to the plan trust and identified the contribution as being for 2023. Because the contribution was made before the due date of Pat’s personal tax return and was identified as a 2023 contribution, it is deemed made on the last day of 2023 and thus deductible on Pat’s 2023 return.
File the appropriate reports
Most employers must file Form 5500 series with the IRS annually (by the last day of the seventh month following the plan year-end date). However, the IRS has created an easier form for individuals with one-participant plans. This form, Form 5500-EZ, is available to plans that cover only the sole owner of a business and that person’s spouse, or partners of a partnership and their spouses.
In general, if you have no more than $250,000 worth of assets in the plan (when combined with assets in all other single-participant plans you maintain), and you have no employees, you don’t need to file any of these annual forms (except in the final plan year, at which time you must file a Form 5500-EZ to show that all plan assets have been distributed).
Questions & Answers
What happens if you contribute more than the maximum allowed to your Keogh plan?
It depends on which limit has been exceeded. If your contributions exceed the Section 415 annual additions limit, your plan may be disqualified unless the excess contribution is corrected in accordance with IRS rules. This is generally accomplished in one of three ways: (1) reallocate the excess to other plan participants who have not met their contribution limits for that year, (2) transfer the excess to a separate account and use these funds for initial contributions the following year, or (3) return employee contributions in the amount of the excess. Be sure to follow IRS guidelines set out in Treasury Regulation Section 415-6(b)(6). In some cases you may need to use one of the IRS correction programs to save your plan from disqualification. These programs, part of the IRS’s Employee Plans Compliance Resolution System (EPCRS), are currently described in Revenue Procedure 2016-51.
If your contribution does not exceed the annual additions limit, but does exceed the amount deductible in any year, the excess contribution will generally be subject to a 10% penalty tax. You can carry forward the excess and deduct it in later plan years (in conjunction with future contributions). Your tax advisor can provide you with more information on these rules.
Special rules apply to excess contributions and deferrals to 401(k) plans [including individual 401(k) plans].