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How Keogh Retirement Plans Work

Keogh Plan Structures and Contribution Limits
U.S. Secretary of Labor Elaine Chao listens to questions as she testifies February 6, 2002 during a hearing on the Enron collapse.
U.S. Secretary of Labor Elaine Chao listens to questions as she testifies February 6, 2002 during a hearing on the Enron collapse.
Alex Wong/Getty Images

A Keogh plan can be set up as either a defined benefit plan (structured like a traditional pension plan) or a defined contribution plan (structured more like a 401(k)).

With a defined-contribution plan, you can contribute up to 25 percent of your earned income. Defined-contribution Keogh plans can take one of two structures:

  • A profit-sharing plan gives you the flexibility to tailor your plan contributions to your business's profitability. In years when you don't make a profit, though, you can't contribute. This plan allows you to contribute varying amounts each year, make in-service withdrawals (withdrawals while you're still employed), and tax-deferred employer contributions, among other things.
  • A money-purchase plan, on the other hand, requires you to contribute when your business makes a profit. Until 2001, this type of plan had a higher contribution limit, but it now offers no savings advantage over a profit-sharing Keogh. The money-purchase plan has a fixed contribution rate. To change this amount, you would have to amend the plan document -- a complicated process.

There are paired or combination Keogh accounts that fuse elements of each account. Ask a retirement plan advisor which plan best suits the needs of your business.

Keoghs may also be set up as defined-benefit plans. A defined-benefit plan guarantees participants a set annual payment. You must calibrate your contributions to ensure that the plan will be able to provide this payment. You'll need an actuary to handle these calculations.

A defined-benefit structure can be lucrative if you're over 50 and earning a lot of money. It can be calamitous if your business' income fluctuates, because even in an unprofitable year you must still contribute to the plan.

The point of a retirement fund is that you don't touch it until retirement. If you take a plan distribution before age 59½, you can expect to pay regular income tax on the distribution, plus a 10 percent early-withdrawal penalty, at a minimum.

Depending on how you've set up your Keogh plan, it may allow certain exceptions, such as hardship withdrawals to help you pay for medical or educational expenses, or to prevent you from facing foreclosure or eviction.

If you're at least 55 and you terminate your business, you may begin receiving plan distributions without penalty. However, if your tax forms continue to show self-employment income, expect the IRS to get curious.

Once you reach retirement age, your options for plan distributions -- whether you receive them as a lump sum or as an annuity, and how your annuity is structured -- will depend on your plan document.

Is all this really better than a 401(k)? On the next page we'll look at the advantages and disadvantages of Keoghs in comparison to other types of retirement plans.