Keogh Plans

Generally, a Keogh Plan is a qualified defined-benefit or a defined-contribution retirement plan set up by a self-employed person or partnership. (The term "Keogh" is used less and less frequently, so the remainder of this discussion will refer to Keogh plans as "qualified plans.") The plan must meet the same eligibility and coverage requirements, contribution limits, vesting requirements, rules for integration with social security, and other plan requirements, as any qualified retirement plan covering corporate employees. This means that it is more difficult and expensive to establish and you can not withdraw funds at any time, but the trade-off is that you can contribute more money each year.

It is not necessary to have any employees to establish a qualified plan. However, if there are employees, they must be allowed to participate in the plan. You do not have to be self-employed on a full-time basis to become eligible to open a Keogh plan. An individual who has another job during the day, but decides to supplement his or her income by turning his or her weekend hobby into a business, is eligible to open a Keogh plan based on the net earnings derived from the part-time self-employment.

Setting up a Keogh plan: To qualify, the Keogh plan must be in writing and approved by the IRS. Further, the terms and conditions of the plan must be communicated to the employees. The plan's provisions must be stated in the plan. You will usually need the help of a professional to establish the plan. You can set up a trust or custodial account to invest the funds or buy a contract from an insurance company.

Contributions to a Keogh plan: There are limits on how much can be contributed to a qualified plan each year. The contribution limit depends upon

• whether the plan is a defined-benefit plan or a defined-contribution plan and
• whether the contribution is for the benefit of an employee or a self-employed individual.

For 2013, the annual contribution limit for a defined-contribution plan is $51,000 or 100 percent of the participant's compensation, whichever is the lower amount. The annual limits for a defined-benefit plan are based on a formula derived to ensure that the annual benefit limitation (for 2013, $205,000 or 100 percent of the participants compensation) is not exceeded. The services of a professional are required to compute these amounts.

If you are self-employed, you can make contributions for yourself only if you have net earnings (compensation) from self-employment in the trade or business for which the plan was set up. These net earnings must be from your personal services, not from your investments. If you have a net loss from self-employment, you cannot make contributions for yourself for the year, even if you can contribute for common-law employees based on their compensation.

Plans can be set up to allow participants to make nondeductible contributions into the plan in addition to the employer's contributions. Even though these employee contributions are not tax deductible, the earnings on them are tax-free until distribution. If you make contributions that are higher than the limits, you are considered to have made a nondeductible contribution which may also be subject to a 10 percent excise tax penalty.

Taxation and tax penalties: Distributions from qualified plans are taxed as ordinary income or in the same manner as distributions from any other qualified plan. There are certain transactions that are prohibited if made between the plan and a "disqualified person." A disqualified person is the employer, a plan fiduciary, a partner owning more than 10 percent of the partnership, highly compensated employees or family members related to any of these. An excise tax penalty of 100 percent is charged on prohibited transactions. It is the disqualified person taking part in the transaction who must pay the tax, not the company or the Keogh plan. One type of prohibited transaction used to be any loan from the plan to the self-employed individual (although this is no longer prohibited).

Required communications: The plan administrator or employer must prepare and file certain annual returns and reports with the Internal Revenue Service relating to the plan, including Form 5500, Annual Return/Report of Employee Benefit Plan. The are also required annual communications that must be provided to all plan participants, and those who are eligible to participate in the plan.

For more information, see our discussion of Keogh plans in the context of employee benefits.