Keogh Plan

A retirement account that allows workers who are self-employed to set aside a percentage of their net earnings for retirement income.

Also known as H.R. 10 plans, Keogh plans provide workers who are self-employed with savings opportunities that are similar to those under company PENSION plans or individual retirement accounts (IRAs). However, Keogh plans allow for a much higher level of contribution, depending on the type of plan selected.

Keogh plans were established in 1962 by the Self-Employed Individuals Tax Retirement Act (26 U.S.C.A. § 1 et seq.) and modified by provisions in the EMPLOYEE RETIREMENT INCOME SECURITY ACT of 1974 (29 U.S.C.A. § 1 et seq.), the Economic Recovery Tax Act of 1981 (26 U.S.C.A. § 1 et seq.), and the Tax Equity and Fiscal Responsibility Act of 1982 (26 U.S.C.A. § 1 et seq.). Keogh plans are considered tax shelters because Keogh contributions, which are deductible from a taxpayer's gross income, and the earnings they generate are considered tax free until they are withdrawn when the contributor retires or dies. At the time of withdrawal, the money is taxable as ordinary income.

Self-employed individuals are defined as people who pay their own SOCIAL SECURITY taxes on their net income. This net income cannot include any investment earnings, wages, or salary. The self-employment does not have to be full-time; in fact, workers who are self-employed on the side can have a separate IRA or other retirement account in the pension plan of the company that pays their wages or salary.

Self-employed taxpayers who own a business and set up a Keogh plan for themselves are also required to set up a Keogh plan for each employee who has worked for their company for at least one thousand hours over a period of three or more years. The level of contributions allowed depends on the type of Keogh plan chosen.

Four different types of Keogh plans are available: profit sharing, money-purchase pension, paired, and defined benefit. Profit sharing plans are most often set up by small businesses because they require a minimal contribution by employees. The maximum amount that may be contributed to this type of plan is 13.04 percent of an employee's net income, up to a total of $22,500 a year.

Money-purchase pension plans are often used by high-income earners because the percentage contribution is fixed on an annual basis; the amount can be changed only once a year or through termination of the plan. This plan's contribution limit is 20 percent of net income, up to a total of $30,000 a year.

Paired plans merge the benefit of the high contributions allowed by money-purchase pension plans with the flexibility of profit sharing plans. For example, an employee may make a money-purchase plan contribution of 7 percent and then contribute between 0 and 13 percent of her or his remaining net income to a profit sharing plan. With this plan, an employee can make the maximum 20 percent contribution the money purchase plan allows but still be able to change the contribution amount throughout the year.

Defined-benefit plans require a minimum contribution of $30,000 a year, so are not available to everyone who is self-employed. Generally, contributors to these plans will employ an actuary to determine the amount of money to be contributed.

Contributors to all Keogh plans are eligible to begin receiving benefits when they are age 59¹/2. At this point the payments are taxed as income. If any portion of the money in a Keogh plan is withdrawn early (before age 59¹/2), a 10 percent penalty tax is imposed, in addition to the normal INCOME TAX. A 15 percent penalty tax is imposed if the contributor does not start receiving benefits before age 70¹/2.

Money can be collected from a Keogh plan in several different ways. The two most common ways are lump sums and installments. Lump sum payments are subject to regular income taxes. However, with a tax break called forward averaging, just one tax is paid. This tax is determined by calculating the total amount that would have been paid if the money had been collected in installments. This advantage reduces the amount of total income tax paid on the plan.

Installment distributions can be set up in several different ways and for various lengths. For example, they can be paid annually for ten years or annually for the number of years the recipient is expected to live. Each distribution is taxed as ordinary income.

In the event that the contributor dies before reaching age 59¹/2, the contributor's heirs will receive the money that is in the Keogh plan, minus income taxes. In this case no penalty taxes are imposed for early withdrawal.

As a general rule of thumb, Keogh plan accounts are judgment proof. Their funds can be seized or garnished only in certain situations. For instance, the government can take Keogh funds to pay personal back taxes owed, and a spouse, ex-spouse, or children may be declared entitled to receive a portion of Keogh money by a court order if the contributor owes ALIMONY or CHILD SUPPORT.