A Keogh Plan is an employer-funded, tax-deferred retirement plan designed for unincorporated businesses or self-employed persons, including those who earn only part of their income from self-employment. Covered under Section 401 (c) of the tax code, Keogh plans are named after Eugene Keogh, the congressman who first came up with the idea. Keogh plans feature relatively high allowable contributions—25 percent of salary to a maximum of $30,000 annually, in some cases—which makes them popular among sole proprietors and small businesses with high incomes. In general, however, Keoghs are more costly to set up and administer than similar retirement programs, such as Simplified Employee Pension (SEP) plans, because they require annual preparation and filing of IRS Form 5500. This long and complicated document usually requires a small business to obtain the services of an accountant or financial advisor. In addition, financial information becomes available to the public under Keogh Plans.
As is the case with other common types of retirement programs, Keogh contributions made on employees' behalf are tax-deductible for the employer, and the funds are allowed to grow tax-deferred until the employee withdraws them upon retirement. The funds held in a Keogh may be invested in certificates of deposit, mutual funds, stocks, bonds, annuities, or some combination thereof. Withdrawals are not permitted until after the employee has reached age 59½, or else the amount withdrawn is subject to a 10 percent penalty in addition to regular income taxes. Usually only the employer may contribute to a Keogh plan. In addition, the employer can establish a vesting schedule through which employees gradually gain full rights to the funds in their accounts over a number of years. Keogh accounts must be opened by December 31 in order to qualify for tax deductions in a given year, but funds can be contributed until the company's tax deadline.
Keogh plans can be structured in a number of ways. Although it is possible to design a Keogh as a defined benefit plan (which determines a fixed amount of benefit to be paid upon retirement, then uses an actuarial formula to calculate the annual contribution required to provide that benefit), most Keoghs take the form of a defined contribution plan (which determines an amount of annual contribution without regard to the total benefit that will be available upon retirement). The three most common types of Keoghs are profit-sharing, money purchase, and combination plans—all of which fall under the category of defined contribution plans.
Profit-sharing Keoghs are the most flexible, allowing the employer to make larger contributions in good financial years and skip contributions in lean years. This type of plan enables the employer to contribute a maximum of 15 percent of compensation, or $22,500 per employee, annually. In contrast, money purchase Keoghs are highly restrictive, requiring the employer to make a mandatory annual contribution of a predetermined percentage of compensation. For this reason, many smaller businesses or those with variable levels of income shy away from this type of plan. On the positive side, money purchase Keoghs allow the highest possible contribution—25 percent of compensation, to a maximum of $30,000 per employee, annually. Combination Keogh plans, as the name suggests, blend some of the features of the other two primary types. Combination plans allow the employer to designate a fixed percentage of mandatory annual contribution, then supplement this amount with additional, discretionary contributions in years when profit levels are high. The total annual contributions in a combination plan cannot exceed 25 percent of compensation or $30,000.
Though Keoghs give small business owners valuable tax deductions and enable them to provide a valuable benefit to their employees, the plans also have some disadvantages. Business owners who employ other people are required to fund a retirement program for nonowner employees if they establish one for themselves. But because the owner's contributions to his or her own plan are based upon the net income of the business—from which self-employment taxes and contributions to employees' retirement accounts have already been deducted—the owner's allowable contributions are reduced. In the case of a money purchase or combination Keogh plan, for example, the business owner is only able to contribute 20 percent (rather than 25 percent) to his or her own retirement fund. But many companies find that the benefits of Keogh plans outweigh the drawbacks. Small businesses that offer such plans can use them to attract potential employees and deter current employees from leaving the company to work for a larger competitor. With their high allowable contribution levels, Keogh plans also give the business owner a good opportunity to achieve a financially secure retirement.
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SEE ALSO: Retirement Planning