Maximum Keogh contributions for the self-employed: a simplified approach.

In many cases, determining the amount of the contribution required to be made to a defined contribution qualified retirement plan f or a business's employees is a relatively simple calculation. Each employee's eligible compensation, as defined in the plan document, is multiplied by the employer's contribution percentage, also stated in the plan document. The total amount for all employees is then taken as a deduction in arriving at net income from the trade or business.

However, determining the amount of the contribution for a self-employed individual is not as simple. In order to compute the allowable deduction for a self-employed individual to a retirement plan (Keogh), the contribution percentage applied to an individual's net income derived from the trade or business must be modified. The percentage stated in the plan is actually applied to the net income from the individual's trade or business after deducting the sum of (1) one-half of the Social Security (OASDI and Medicare) self-employment taxes and (2) the deduction for contributions to the self-employed retirement plan by the self-employed individual.

In computing the self-employment taxes, the applicable tax rates are applied to 92.35% of the net income from the trade or business. The applicable combined OASDI and Medicare tax rate is 15.3% of net self-employment earnings of up to $57,600 for 1993 ($60,600 for 1994). Due to the uncoupling of the OASDI and Medicare base limitations, the Medicare tax of 2.9% applies to the excess of net self-employment income above the OASDI threshold limit. The Medicare tax base is limited to $135,000 for 1993. After 1993 there is no limitation, and all net self-employment income is subject to the Medicare tax.

There are two additional limitations that apply to both employees and the self-employed. The amount of the Keogh contribution for a defined contribution plan for each employee and self-employed person is limited to $30,000. This amount will be increased for inflation when the cost-of-living adjustments cause the annual limitation for a defined benefit plan to exceed $120,000 (for 1994 the limit is $118,800). In addition, the amount of income that may be considered in computing the contribution is also limited. Prior to the Revenue Reconciliation Act of 1993 (RRA), the income limitation was $200,000 adjusted for inflation ($23,9,840 for 1993). The RRA reduced the income limitation to $150,000 for plan years beginning after Dec. 31, 1993. The new limitation will be adjusted for cost-of-living adjustments after 1994, but only in increments of $10,000.

It should be noted that the reduction in the income limitation will adversely affect a number of individuals who were previously able to contribute the $30,000 maximum amount to their plan. This is especially true for those individuals who had a 15% profit-sharing plan and no pension plan. Individuals whose net self-employment earnings met or exceeded the $235,840 limitation in 1993 were able to contribute $30,000 to their Keogh plan. However, in 1994 the maximum amount they can contribute to the same plan will be $22,500. Therefore, self-employed individuals should consider setting up a separate pension plan prior to Dec. 31, 1994 in order to maximize their annual Keogh contribution. By establishing a separate money purchase pension plan with a 10% contribution rate, the self-employed individual would be able to raise the combined contribution rate to 25% of net self-employment income (15% for the profit-sharing plan and 10% for the pension plan).

As in most tax and investment decisions, there are several costs at must be weighed against the benefit obtained from the additional Keogh contribution.

One of the primary costs is that of making pension contributions necessary to cover employees of the business. in many cases, the cost may be minimal. However, if the self-employed individual has many employees or a number of highly compensated employees, the cost of making the contributions for these employees may outweigh any benefit received by the self-employed individual. A second consideration is whether the income of the self-employed individual is stable enough to permit the establishment of a pension plan. Unless the employer receives a waiver from the Federal government, a pension plan requires payment of the pension contribution regardless of whether the business makes a profit. Therefore, a self-employed individual with employees would be required to make a pension contribution on behalf of the employees even if he had no self-employment income for the year and could not make any contribution on his own behalf. A third consideration is the cost of creating and administering a second retirement plan. Most of these considerations may be of minimal consequence for a self-employed individual if there are no employees.

Regardless of whether one or two defined contribution retirement plans exist, the calculation of the Keogh contribution for a self-employed individual is not a simple matter. However, it is possible to construct a table to simplify the calculation. See the exhibit on page 468 for two sets of simplified formulas for calculating the maximum Keogh contribution for a self-employed individual. Formulas are provided for the three most common contribution percentages.

Calculating the Maximum Keogh Contribution
For 1993 Keogh contributions for a self-employed individual:
                           Multiply by   Subtract
Up to $62,371
  10%                      0.0844866      N/A
  15%                      0.1212199      N/A
  25%(a)                   0.1858705      N/A
From $62,371 to $146,183
  10%                      0.0896918       324.66
  15%                      0.1286882       465.81
  25%(a)                   0.1973218       714.24
over $146,183(b)
  10%                      0.0909091        502.61
  15%                      0.1304348        721.12
  25%(a)                   0.2000000      1,105.74
For 1994 Keogh contributions for a self-employed individual:
                           Multiply by    Subtract
Up to $65,620
  10%                      0.0844866       N/A
  15%                      0.1212199       N/A
  25%(a)                   0.1858705       N/A
Above $65,620(b)
  10%                      0.0896918       341.56
  15%                      0.1286882       490.07
  25%(a)                   0.1973218       751.44
(a) Money purchase plans only (or a combination of a money purchase
plan and a profit-sharing plan with a combined contribution percentage
of 25% (between them).
(b) $30,000 maximum contribution.
  For 1994, the $150,000 maximum earned income limitation (after
statutory modifications) that may be considered for purposes of computing
contributions to a qualified retirement plan results in the following
maximum amounts:
               Maximum
               net income
Contribution    before
percentage     modifications   Contribution
  10%          $171,048        $15,000
  15%           178,649         22,500
  25%           155,844         30,000