What is a Keogh Plan? Definition, tax rules, what you need to know

  • A Keogh plan is a type of retirement investment account for the self-employed and business owners.
  • Contributions to a Keogh plan are made before tax, while pension payments face income tax.
  • Certain types of Keogh plans may have higher contribution limits than other retirement accounts.
  • Visit the Insiders Investing Reference Library for more stories.

A Keogh plan is a type of retirement account that can be set up by the self-employed. Named “HR 10” or “Qualified Plans” by the IRS, Keogh plans were originally the only way for unincorporated companies to sponsor retirement plans for their employees. Now that other options like SEP IRAs and 401 (k) plans are popping up, Keogh plans are falling out of fashion.

Still, Keogh plans are not completely extinct and may offer business owners a smart way to save up for retirement.

How do Keogh plans work?

Like other retirement accounts, Keogh plans invest your cash contributions in a variety of assets, such as stocks, bonds, and ETFs. You and potentially your employer can contribute before tax to a Keogh plan up to the limits set by the IRS, described below.

When it’s time to withdraw from your Keogh plan, you can choose to receive your money in installments or a lump sum. You can choose how often your installment payments should be made and the amount in each. If you choose a lump sum, it is taxed once on the amount you would have paid if you had charged in installments, reducing the overall tax burden.

Self-employed small business owners and limited liability companies can also open Keogh plans for themselves. These qualified employers must create Keogh plans for their employees who have worked in the company for at least 1,000 hours over three or more years.

Common law employees, partners, and independent contractors cannot create Keogh plans.

Types of Keogh Plans

There are two types of Keogh schemes: qualifying defined contribution schemes and qualifying defined benefit schemes.

Qualified contribution schemes is largely influenced and regulated by the amount deposited in the account. The contributions, together with the account’s earnings and losses, will determine the benefits paid out upon retirement.

Contribution-based schemes can be further divided into profit-sharing schemes, where an employer can deposit an amount based on the company’s profits into an employee’s account, and cash pension schemes, where the contributions are fixed and not based on profits.

Qualified benefit-based schemes focus more on guaranteeing firm benefits. To do so, these schemes often involve calculations to determine the contributions and investments needed to meet the defined benefits.

Rules for contributions and withdrawal

Contributions to a Keogh plan are made before tax, so you can deduct your contribution amount from your taxes for the year you made the contribution. You pay tax on the total balance of the plan when you retire.

The IRS limits how much you can contribute to a Keogh plan each year, depending on the type of plan.

Payments from a Keogh plan can be made impunity from the age of 59 ½. Payments before this time are subject to a fine of 10%, in addition to ordinary income tax.

You are obliged to take distributions from the account before 70 ½ years, otherwise a fine of 15% will be imposed.

Pros and cons of Keogh plans

It is important to understand both the pros and cons of a Keogh plan before choosing it as your retirement savings.

Keogh plans offer versatility to the self-employed, saving up for retirement. Keogh schemes can be opened as either a defined contribution or defined benefit plan, allowing scheme sponsors to choose from based on their pension objectives.

In addition, Keogh plans have high IRS contribution limits, making them a more attractive option for aggressive savers.

But since Keogh plans have been overtaken by newer retirement accounts, they can be harder to find. Keogh plans are also more complicated and involve several administrative obstacles and costs. This includes the likely need for professional management due to the calculations required to set up a defined benefit plan.

Keogh vs. 401 (k)

A 401 (k) plan is a newer alternative to a Keogh plan, and although they have similarities, it is their differences that have helped the 401 (k) gain more popularity.

A 401 (k) is an employee-sponsored qualified contribution-based scheme. Typically, employees can open a 401 (k) if their employer offers one. The employee makes contributions, and sometimes, depending on their policies, the employer will also contribute a percentage.

While Keogh plans are only available to the self-employed and their employees, 401 (k) plans are more accessible. Those who are self-employed can open a solo 401 (k), also known as a one-participant 401 (k) or individual 401 (k), which are almost identical to traditional 401 (k) plans.

One-participant 401 (k) plans allow self-employed workers to contribute an additional 25% of net earnings to the account on top of the traditional contribution limits ($ 19,500 in 2021), for a total of $ 58,000 for 2021.

401 (k) plans are relatively easy to configure and manage and do not come with the administrative burdens that Keogh plans do.

The economic takeaway

A Keogh plan can be a practical retirement savings for those who are self-employed. Keogh schemes offer savers high contribution limits, pre-tax contributions and the option to choose between defined benefit and defined contribution types.

However, Keogh plans are becoming less popular and less accessible as lower maintenance 401 (k) and IRA plans become more and more attractive savings options. Keogh plans can also come with additional costs, such as professional management, so it’s important to weigh whether a Keogh plan is smartest for both your current financial situation and your retirement goals.

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