How Keogh Retirement Plans Work

Rules are great -- when they work in your favor, and Keogh plans have quite a few of them. Let's look at the basics.

Keoghs serve as tax shelters. You receive a deduction for the money you contribute to the plan. Taxes are also deferred as the money compounds in the plan. You don't pay taxes on the plan's earnings until you start drawing down the account -- that is, receiving payments, or distributions. At that point the payments are treated as ordinary taxable income.

Keogh plans have higher contribution limits than many other retirement plans, because you're basically contributing as both an employee and an employer. For the same reason, your FICA taxes are higher when you're self-employed.

At first glance, a Keogh's 25 percent limit seems far better than an IRA's flat $5,000 cap, or even a 401(k)'s 15 percent limit. There's a catch, though. With a Keogh, you're not contributing a percentage of annual compensation, as you would with employer-sponsored plans. You're contributing a percentage of earned income -- your self-employment income less your self-employment expenses (including the deductible 50 percent of your self-employment tax). That can set the contribution bar a bit lower, to something like 20 percent of your gross income. If your self-employment earnings are relatively small, a Keogh plan alone may not provide adequate retirement savings.

You're eligible to participate in a Keogh retirement plan if you are:

You are not eligible to participate if you are:

To set up a Keogh, you must adopt a written plan. IRS publication 560 can help you do it, but the documentation is extensive. It's best to leave the paperwork to financial organizations such as banks, mutual fund companies, trade professionals and insurance companies. These institutions have access to "master" or "prototype" plans that the IRS has pre-approved. They also typically update these plans as the tax code changes.

If you have employees, you must notify them of the plan's contents in writing and, if they're eligible, provide them the opportunity to participate. A Keogh plan may specify a minimum age and must specify vesting requirements for participants.

If some of your employees are not co-owners of the business, their participation in the plan imposes additional restrictions on you. You probably won't be able to use a prototype plan. You'll need to follow nondiscrimination rules, which are basically ways of ensuring that plan participants' savings opportunities are proportionate and fair.

Which plan structure is right for you? How can you realize the most savings? Find the ka-CHING! on the next page.

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:

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.

What do you stand to gain from a Keogh plan? They're tailored to the self-employed, who typically have a higher tax burden than people who work for other corporations. For that reason, tax is deferred until you withdraw the funds. You typically don't pay any taxes on the plan itself. And like all tax-exempt retirement plans, it's protected from creditors by federal bankruptcy law.

Your contributions to a Keogh plan are deducted from your gross income rather than your net income. They also have generous contribution limits. If you're under age 50, in 2008, an employer-sponsored 401(k) allows you to contribute up to $15,500 of your pay. A SIMPLE or SIMPLE 401(k) allows up to $10,500. A traditional or Roth IRA allows you contribute up to $5,000. By contrast, a Keogh allows you to contribute up to 25 percent of your earned income.

But just like anything else, there are disadvantages, too.

The IRS has been auditing more Keogh plans. By some estimates, as many one-third of these plans are noncompliant [source: Rosen]. If your plan is found to be noncompliant, none of your contributions are tax-deductible. That means your taxable income for the applicable years will be higher, and you'll owe back taxes as well as interest and late-payment penalties.

The retirement plan that's right for you depends on many factors, including whether you have employees, how much you expect to earn, how old you are and how comfortable you are with plan administration and tax forms. You can learn more by following the links on the next page.