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KEOGH PLANS
History of Keogh Plans
While incorporated businesses have long been able to set up retirement plans for their employees, unincorporated businesses were not able to do so until 1962. At that time, plans for unincorporated businesses were called "Keoghs" or "HR-10" plans, and financial organizations offering qualified plans had to maintain two separate sets of plan documents-one for corporations and one for unincorporated businesses. However, in 1984, organizations were allowed to use the same qualified plan document for either corporations or unincorporated businesses, although the nickname "Keogh" is still commonly used for either type of business using this plan.
A Keogh is one type of qualified plan, and must meet all of the requirements under Section 401(a) of the Internal Revenue Code. Of the various types of qualified plans, Keoghs fall under the category of defined contribution plans, and are set up as either a Money Purchase Plan or a Profit Sharing Plan, or a combination of the two plans, often referred to as a "Paired Plan."
Contributions
Contributions to a Keogh are made by the employer on behalf of eligible employees. The contribution limit is up to 25% of compensation or $30,000, whichever is less. However, the options listed above to adopt either a Profit Sharing Plan or a Money Purchase Plan, or to pair the plans together, will affect the flexibility an employer has in contributing each year as well as their ability to contribute the maximum amount.
A Money Purchase Plan is considered a "pension plan," and therefore is subject to minimum funding requirements for the employer to fund the plan each year. When the plan is adopted, the employer will indicate what fixed percentage of compensation will be contributed each year, which may not be greater than 25%. (Some plans allow the employer to express the contribution as a fixed dollar amount rather than a percentage of income.) Unlike Profit Sharing Plans, contributions to a Money Purchase Plan are not based on business profits, and are required to be made for employees, even if the business sustains a loss for the year. Failure to make the required contribution subjects the employer to penalties from the IRS. It is usually not recommended that an employer amend their plan to reduce the Money Purchase contribution. Amending a Money Purchase Plan's contribution formula, either up or down, is risky and could cause complications with the IRS for the employer. For that reason, it is often preferable to pair a Money Purchase Plan with a Profit Sharing Plan.
A Profit Sharing Plan is a "discretionary" plan, and depending on the terms of the plan adopted by the employer, usually allows some flexibility in making contributions from year to year. The contribution limit on a Profit Sharing Plan is from 0% to 15%, up to $25,500. Unlike Money Purchase Plans, an employer can choose each year how much to contribute within that range. They may even be allowed to skip a year or two of contributions; however, contributions must still be made on what the IRS terms "a substantial and recurring basis."
Pairing a Money Purchase Plan with a Profit Sharing Plan allows an employer the maximum annual tax deduction while permitting some flexibility. For example, an employer can adopt a Paired Plan with a fixed annual contribution of 10% to a Money Purchase Plan, and have the flexibility of contributing up to 15% to a Profit Sharing Plan, with the overall $30,000 limit. In other words, in "good" business years, the employer can contribute the maximum amount, while if business needs dictate, in this example the employer is only required to contribute 10% to the Money Purchase Plan.
In most Keogh plans, the employer must contribute the same percentage of each eligible employee's compensation as he contributes for himself. In certain situations, an employer may want to consider integrating Keogh contributions with the Social Security contributions made for their employees. Social Security integration (also known as "Permitted Disparity") allows an employer to credit the Social Security contributions made for employees toward the amount they need to contribute for their Keogh plan, resulting in a higher percentage of compensation in a Keogh for employees who earn above the Social Security wage base.
Beginning in the year 2000, contributions to a Keogh are based on a maximum income of $170,000 (for 1999 the maximum compensation was $160,000). For the self-employed individual, contributions must be based on "earned income," which is comprised of net business profits, reduced by one-half of self-employment tax, less the Keogh contribution. Incorporated business owners need to be aware that their contributions are based only on their W-2 wages, not business profits. It is important to not over-contribute to a Keogh plan. Depending on the circumstances, excess amounts (technically considered by the IRS as "nondeductible contributions") are usually subject to an IRS penalty and must be carried forward to future years' contributions, rather than being removed from the plan or returned to the employer.
Calculating Contributions
Although the formula can vary, the following is one example of calculating a Keogh contribution for a self-employed individual's Paired Plan:
A. Net business profits $100,000
B. Deduct ½ of self-employment tax $ 7,650
C. Adjusted net business profits $ 92,350
D. Money Purchase Plan Contribution .10
Percentage, in decimal form
(Fixed percentage set when plan is established)
E. Profit Sharing Plan Contribution .15
Percentage, in decimal form
(Percentage can vary every year from 0% to 15%)
F. Total Contribution Percentage, in decimal form .25
G. Contribution Factor 1.25
(Add 1.00 to contribution percentage)
H. Adjusted earned income $ 73,880
(Divide C by G)
I. Enter maximum "Earned Income" $170,000
J. Enter the smaller of H or I $ 73,880
K. Preliminary Money Purchase Amount $ 7,388
(Multiply J by D, round down to closest dollar)
L. Maximum Money Purchase Amount $ 30,000
(Enter $30,000)
M. Money Purchase Plan Contribution Amount $ 7,388
(The lesser of K and L)
N. Preliminary Profit Sharing Amount $ 11,082
(Multiply J by E)
O. Maximum Profit Sharing Amount $ 22,612
(Subtract M from L)
P. Profit Sharing Plan Contribution Amount $ 11,082
(The lesser of N and O)
Q. Total Paired Plan Contribution Amount $ 18,470
(Add M and P)
Employee Eligibility
An employer must make Keogh contributions to employees who meet the following requirements:
- Age: An employer can require an employee to be at least 21 years of age to be eligible to participate.
- Years of Service: If the plan document provides for Keogh contributions to be immediately vested, an employer can require two years of service. With plans that have a vesting schedule, an employer can only require one year of service. In general, 1,000 hours is considered a year of service, so in some cases this might exclude part-time employees from being eligible to participate.
Obviously, an employer can choose to be more lenient in determining employee eligibility, but cannot be more restrictive than the above requirements. An employer also has the option to automatically include all individuals employed in the company at the time the plan is adopted, but require future employees to meet certain eligibility requirements.
Keogh Withdrawals
Unlike SEP and SIMPLE IRA's, money in a Keogh cannot be accessed, even if a participant feels they are willing to pay an early withdrawal penalty. Generally distributions can only be taken if a "triggering event" occurs, which includes separation from service, termination of the plan, or attaining the age of 59½. Some Profit Sharing plans may permit in-service distributions, but many do not. To withdraw funds from a Keogh without a triggering event risks the entire plan being disqualified by the IRS.
Administration of Keogh Plans
Depending on whether the Keogh is for a sole proprietor or a business with several employees, administration of the plan can range from being minimal to very involved. Every Keogh plan must have a plan administrator, who may be the employer, an accountant, or a professional pension advisor. The duties of the plan administrator include:
- Providing participants with a Summary Plan Description
- Retaining copies of the plan document and any amendments to the plan
- Obtaining a fidelity bond
- Monitoring plan eligibility
- Calculating annual contributions and reviewing distribution requests
- Filing the 5500 series return with the IRS annually
Deadlines for Keogh Plans
Federal law requires that a Keogh be established by the last day of the employer's taxable year, which for calendar year employers is December 31. Some financial institutions may require that a minimum contribution be made by year-end as well. The deadline for any remaining contributions is the employer's tax filing deadline, including extensions. For calendar year unincorporated employers, their tax filing deadline is April 15, with possible extensions until October 15. Calendar year corporate employers' tax filing deadline is March 15, with possible extensions until September 15. This is an important distinction when a Money Purchase Plan is involved. In order to avoid a funding deficiency penalty of 10%, contributions must be made by 8½ months after the end of the plan year. For corporate employers, this coincides with their September 15 extension. However, for unincorporated employers, they must make their mandatory Money Purchase Plan contribution by September 15, even if their tax filing deadline has been extended through October 15.
One of the common problems associated with a Keogh deals with the year-end deadline to establish the plan. Many employers or self-employed individuals learn of their potential to have a large tax deduction through this plan and at the end of the year, rush to set one up at the last minute without knowing the details of the plan. Later they may find they are in a plan that involves more than they anticipated, and find that another type of plan may have been more appropriate for their business. In many situations, Keoghs are a perfect fit for a small business, but once adopted, it is considered by the IRS to more or less be a permanent retirement plan. It is strongly advised that small business owners research all their options before adopting a complex retirement plan such as a Keogh.
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