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:
- self-employed, a small business owner, or an active partner in an unincorporated business who performs personal services for the company
- a sole proprietor who files Schedule C
- in a partnership whose members file Schedule E (in this case, the partnership, not you, must establish the Keogh plan)
- working for another company, but working for your own business as well (for example, if you're a writer with a day job and you're earning royalties on your first book, the royalties count as self-employment income)
You are not eligible to participate if you are:
- a salaried worker for an incorporated business, with no other source of income
- retired and not receiving compensation from a business
- a volunteer at the business that offers the plan
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.