The Keogh Plan: Saving for Retirement While Self-Employed

You can’t run a company without managing your business finances well, and saving and planning for retirement is an important part of this. Retirement planning is particularly challenging as a small business owner because you’re on your own, and some of the more well-known retirement plans are unavailable to you. For example, only a corporation can establish and administer an employer 401(k) plan or 403(b) plan, and conventional pensions aren’t available to self-employed individuals.

Thankfully, Keogh plans, more often called HR 10 or qualified plans, offer an alternative way for self-employed individuals to invest in their retirement. This can be a great option for higher-income small business owners, such as doctors and lawyers. It puts you more in control of your retirement savings and potentially allows you to save more than you could with other retirement vehicles. We’ll explain more about the Keogh plan, the options for saving, and how to start one. 

Keogh Plan Eligibility

Named for its creator, Congressman Eugene Keogh, a Keogh plan is a type of retirement account for self-employed individuals, certain types of small business entities, and their employees. It is not available to freelance workers or independent contractors. The IRS commonly refers to a Keogh plan as an HR 10 plan or qualified plan.

All of the following are eligible to use a Keogh plan:

• Self-employed professionals, such as doctors and lawyers
• Small businesses that are set up as sole proprietorships, partnerships,  or limited liability companies (LLCs)
• Eligible employees of these small businesses, though the employer must make the full contribution. Eligible employees must be 21 years old and work at least 1,000 hours per year for your company.

Just like an Individual Retirement Account (IRA), a Keogh plan can be used to invest in stocks, bonds, and mutual funds, and certificates of deposit. You can decide the mix of funds that you want to invest in. The younger you are, the wiser it is to invest in more volatile investment options like stocks. You should be more risk averse as you approach retirement age.

Types of Keogh Plans

There are two main types of Keogh plans. We’ll discuss each one in turn.

Defined Contribution Plans

Defined contribution Keogh plans are exactly as they sound. These are accounts in which you define the contribution that you make each year to your plan. There are two types of defined contribution plans.

Profit Sharing Plans

With a profit sharing Keogh plan, you decide on a dollar amount that you want to contribute each year. Your company doesn’t necessarily have to be profitable in order to set up a profit sharing plan. Your contribution amount can change from year to year, but there’s a cap on contributions that’s equal to 25% of your net self-employment earnings.

Money Purchase Plans

Money purchase plans require that an enterprise contribute a predetermined percentage of its income to a Keogh account each year, and that number is decided in the founding documents for the business. If the company fails to reach this contribution level, they must pay a penalty to the IRS. You can contribute up to 25% of the company’s earnings, and you cannot change the percentage level if your company made a profit.

In the past, businesses chose this rigid option as opposed to the flexible profit sharing plan because the limits on both contributions and deductions were higher with this type of account. However, the IRS rescinded this incentive, and set the same maximums for money purchase plans as profit sharing plans. Thus, a small enterprise is likely to select this version of a Keogh account only if an investor or lender demands it. The advantage of this  choice is that it provides certainty regarding Keogh contributions.

Defined Benefit Plans

With a defined benefit Keogh plan, the business owner selects the benefit they wish to receive upon retirement, and works backward to determine the annual contribution required to achieve that amount. The contribution required and the deduction allowed to reach your benefit goal are complex to compute. An actuary uses variables like your age and expected return on investments to calculate this figure.

You can contribute up to 100% of your compensation to a defined benefit plan, which makes this a good option for high income earners. However, for 2019, the IRS has set the maximum annual benefit at $225,000. Every year, there has typically been a slight cost of living increase in the maximum annual benefit. This is noteworthy but not a guarantee of future hikes.

When Can You Access Money from a Keogh Plan?

As with any qualified retirement account, you can withdraw money from a Keogh account without penalty as early as 59 and a half years old. The latest you can begin withdrawals is by age 70 and a half.

If you choose to access your money before age 59 and a half, you’ll take what is called an early distribution. An early distribution is subject to current federal and state income taxes at the time of withdrawal, plus a 10% penalty. You might owe state tax penalties as well. There are a few exceptions to the rules against early distribution, for issues like large medical bills and disability.^[1]

If you reach your seventies and are still working, you can keep contributing to your Keogh plan, but you must also make required withdrawals.

How are Keogh Plan Contributions Taxed?

Similar to a 401(k) plan, a Keogh plan is a tax-deferred retirement account. This means you don’t pay income taxes on the money as you make contributions to your account, which lowers your total tax burden each year you pay into the plan. Eventually, though, you’ll be taxed on this money, when you withdraw from the account during retirement.

By the time you make withdrawals, you might be in a lower tax bracket, as you’re no longer employed and making less money. So, you will pay fewer taxes than you would have had you been taxed on your contributions upfront.

Keogh Plans vs. Other Self-Employed Retirement Plans

The Keogh plan is just one of many retirement plans for self-employed individuals and small business owners. Here are some other retirement plan options and they compare to the Keogh plan:

• Solo 401(k) – This plan is similar to a regular 401(k), but a Solo 401(k) is designed especially for self-employed individuals. You’re eligible only if you have no employees.
• Traditional IRA – Traditional IRAs are the simplest types of retirement accounts to set up. Contribution limits are much lower than a Keogh plan, but the administrative burden is also much lower.
• SEP IRA – SEP plans are very similar to defined-contribution Keogh plans, but require less paperwork than a Keogh plan. Unlike a Keogh plan, there’s no need for annual reporting with an SEP, and you don’t have to contribute to an SEP every year.
• SIMPLE IRA – A SIMPLE IRA is a good option for larger businesses and those with employees because employees can make their own contributions. However, employers are generally required to make matching contributions.
• Roth IRA – A Roth IRA lets you set aside after-tax income for retirement. This option is best for those who think they’ll be in a higher tax bracket when they retirement. However, there are income limits on who is eligible and the contribution limits are lower than a Keogh plan.

If you have an existing Keogh plan but decide that one of these other plans is a better choice for you, you can usually rollover assets to the new plan. Make sure you contact your plan provider and complete your rollover within the specified time frame (usually 60 days) to avoid being taxed for early withdrawal.

Usually, it’s also possible to have multiple retirement plans. For instance, you can have a Keogh plan and an IRA. However, there might be additional limits on how much you can contribute to each plan.

How to Set Up a Keogh Plan

In order to set up a Keogh plan, you must work with a plan administrator who provides these types of plans. Banks, insurance companies, private brokers, independent administrators, law firms, and accounting firms provide Keogh plans. You must hire an actuary for a defined-benefit plan.

In general, you must establish a Keogh plan by December 31 of the year that you want the plan to take effect, and make your initial contributions by April 15 of the following year. If you qualify for an extension on filing your tax return, that also gives you more time to fund your Keogh plan.

Anyone with a Keogh plan must file Form 5500 with the IRS each year.

Bottom Line: Is a Keogh Plan Right for You?

The main reason that small business owners select a Keogh plan is that they have high contribution and deduction limits. These limits are based on percentages of net profit, however, which means that you’ve already deducted self-employment tax and contributions to employee retirement funds, so these amounts aren’t as attractive as they initially seem.

In addition, Keogh accounts are expensive to establish and to maintain. These plans require complicated IRS paperwork yearly and incur costly annual fees. To get it right, you need to enlist the assistance of an accountant or other tax professional.

If your business has any employees, the law requires that you allow them to participate in your Keogh plan. Unlike other qualified plans, however, the employer is the sole investor; the employee contributes nothing to the plan. While you can deduct from your own tax burden the contributions that you make to your Keogh account on your employees’ behalf, you’ll still foot their entire retirement bill.

Finally, if you create a Keogh account, your financial information becomes public record. Most small businesses aren’t ready to air their financial dirty laundry, and understandably so.

Thus, if you’re the sole employee of your company, you’re well-to-do, and you desire to save more money at a faster rate—perhaps because you plan to retire soon—the Keogh account is a good choice for you. For most individuals, however, the disadvantages of a Keogh plan outweigh the advantages—which is why you rarely see them discussed in retirement planning today.

Article Sources:

1. IRS.gov. “Retirement Topics: Exceptions to Tax on Early Distributions“