Chapter 22: HR 10 (Keogh) plan.
A Keogh plan, sometimes referred to as an HR 10 plan, is a qualified retirement plan that covers one or more self-employed individuals. A self-employed individual is a sole proprietor or partner who works in his or her unincorporated business. Like all qualified plans, a Keogh plan enables those covered under the plan to accumulate a private retirement fund that will supplement their other pension and Social Security benefits.
A Keogh plan works much like any qualified plan; the details of the various types of qualified plans such as defined benefit or profit sharing plans are discussed in separate chapters of this book. This chapter focuses on the special features of a qualified plan that covers self-employed individuals.
WHEN IS IT INDICATED?
1. When long-term capital accumulation, particularly for retirement purposes, is an important objective of a self-employed business owner.
2. When an owner of an unincorporated business wishes to adopt a plan providing retirement benefits for regular employees as an incentive and employee benefit, as well as retirement savings for the business owner.
3. When a self-employed person has a need to shelter some current earnings from federal income tax.
4. When an employee has self-employment income as well as income from employment, and wishes to invest as much as possible of the self-employment income and defer taxes on it.
1. Keogh contributions are deducted from gross income, and tax is deferred until funds are withdrawn from the plan at a later date.
2. Income generated by the investments in a Keogh plan is also tax-deferred until it is withdrawn from the plan. This reinvestment of income and build-up of tax deferred earnings is one of the main features that make Keogh plans attractive.
For example, the following table shows the results of investing $7,500 annually in a Keogh plan where the rate of return is 8%:
Tax Number of Total Deferred Total Years Contribution Interest Value 5 $37,500 $10,019 $47,519 10 75,000 42,341 117,341 15 112,500 107,432 219,932 20 150,000 220,672 370,672 25 187,500 404,658 592,158
As can be seen, the tax-deferred earnings portion of the program will eventually exceed the amount of personal annual contributions. This is a strong incentive to start early and continue to make the largest possible contribution to such a plan.
3. Under current law, plan loans to owner-employees are subject to the same rules as are applied to regular employees (generally up to $50,000 or half the vested benefit). (1)
4. The limits on Keogh plan contributions, as for all qualified plans, are more liberal than those applied to IRAs (individual retirement accounts). IRAs are subject to the following annual contribution limits: $5,000 in 2009 ($10,000 for an individual and spouse). In contrast, the maximum contribution under a defined contribution Keogh plan is $49,000 (in 2009, as indexed). (See the discussion under "Types of Keogh Plans" below regarding how to take advantage of the full $49,000 limit). Thus, a self-employed person may be eligible to contribute more than 10 times as much to a Keogh plan as to an IRA. In addition, deductions for IRA contributions may be limited if the individual (or his spouse) is an active participant in a qualified retirement plan (see Chapter 6).
5. From the viewpoint of an employee of an unincorporated business, Keogh plans are advantageous because employees of the business must participate in the plan (within the limits of the coverage requirements for qualified plans described in Chapter 7).
6. Certain employers adopting a plan may be eligible for a business tax credit of up to $500 for "qualified startup costs." See Chapter 10 for details.
1. Keogh plans involve all the costs and complexity associated with qualified plans. However, for a small plan, particularly one covering only one self-employed individual, it is relatively easy to minimize these factors by using prototype plans offered by insurance companies, mutual funds, banks, and other financial institutions.
2. If a self-employed person has a significant number of employees, the qualified plan coverage requirements, which require nondiscriminatory plan coverage (see Chapter 7), may increase the cost of the plan substantially.
3. As with all qualified plans, there is a 10% penalty, in addition to regular federal income tax, for withdrawal of plan funds generally before age 591/2, death, or disability (see Chapter 8).
4. Again as with regular qualified plans, benefit payments from the plan generally must begin by April 1 of the later of (a) the year after the plan participant attains age 70 1/2, or (b) the year the participant retires; however, in the case of a more-than-5% owner, payments must begin by April 1 of the year after attainment of age 70 1/2, regardless of whether the participant has retired. There is a penalty for noncompliance (see Chapter 8). Thus, Keogh plans, like all qualified plans, cannot be viewed as a means of avoiding income tax, or passing assets to succeeding generations tax free.
5. Life insurance in a qualified plan for a self-employed person, described below, is treated somewhat less favorably than for regular employees.
TYPES OF KEOGH PLANS
In general, any type of qualified plan can be designed to cover self-employed persons. However, the typical Keogh plan covering one self-employed person, and possibly the spouse of the self-employed person, as well as a few employees, is usually designed as a defined contribution plan without a fixed contribution formula (profit sharing type of plan).
In a defined contribution plan, an annual contribution of any amount up to 25% of the total payroll of plan participants is generally deductible. (2) If the plan is the profit-sharing type, plan contributions can even be omitted entirely in a bad year. However, the IRS requires "substantial and recurring" contributions, or the plan may be deemed to have been terminated. (3) This contribution flexibility is very advantageous for a small business, the income of which may fluctuate substantially from year to year.
As with all qualified plans, the compensation base is limited to $245,000 (in 2009, as indexed). (4) This imposes a limit on Keogh profit sharing plans for self-employed persons with earned income of $245,000 or more-an income level that is not unusual for a successful professional. The annual additions limit (see Chapter 7) effectively limits profit sharing plan contributions to $49,000 in 2009. (5)
A partnership or proprietorship may also establish a 401(k) plan, including a solo 401(k) plan (for details, see Chapter 20). Matching contributions made to a 401(k) Keogh plan on behalf of a self-employed person are not treated as elective employer contributions, thus they are not subject to the $16,500 (in 2009) annual limit. (6)
A money purchase plan contains a fixed annual contribution formula of up to 25% of earned income, for self-employed persons (25% of compensation for any regular employees covered under the plan). (7) However, a money purchase plan is subject to the Code's minimum funding requirements (see Chapter 7). These require the employer to make contributions to each employee's and self-employed person's account each year equal to the percentage of compensation stated in the plan. Such contributions are mandatory, regardless of good or bad business results for the year.
A partnership or proprietorship can adopt other types of qualified plans as well. A defined benefit plan (see Chapter 14) is attractive to the older self-employed person who is just starting a plan, because the actuarial funding approach allows a greater relative contribution for older plan participants. Often, considerably more can be contributed annually to a defined benefit plan than the $49,000 maximum (in 2009, as indexed) for defined contribution plans.
Partnerships and proprietorships can also adopt cross-tested or other age-weighted plans (see Chapter 21) with self-employed persons as participants. These plans, like defined benefit plans, allow contributions to be weighted (that is, provide contributions equal to a higher percentage of compensation) for older plan entrants, who tend to be the owners of the business.
HOW ARE KEOGHS DIFFERENT FROM OTHER QUALIFIED PLANS?
The unique feature of a Keogh plan, as compared with qualified plans adopted by corporations, is that the Keogh plan covers self-employed individuals, who are not technically considered "employees." This leads to some significant special rules for self-employed individuals covered under the plan.
The most important special rule is the definition of earned income. For a self-employed individual, "earned income" takes the place of "compensation" in applying the qualified plan rules. Earned income is defined as the self-employed individual's net income from the business after all deductions, including the deduction for Keogh plan contributions. (8) In addition, the IRS has ruled that the self-employment tax must be computed and a deduction of one-half of the self-employment tax must be taken before determining the Keogh deduction. (9)
To resolve the potential complexity of this computation, IRS Publication 560 specifies the following steps in determining the Keogh deduction:
(1) determine net income from Schedule C income;
(2) subtract one-half of the actual amount of the self-employment tax; and
(3) multiply the result by the "net" contribution rate from the rate table below.
This computation can easily be transferred to a computer worksheet.
Example: Len earns $100,000 of Schedule C income in 2009. His self-employment tax is $14,129.55. (The net income amount of $100,000 is first reduced by 7.65%, leaving $92,350 net earnings subject to the self-employment tax-$92,350 x 15.3 (Combined OASDI and HI rate) = $14,129.55.) The deduction for one-half of the self-employment tax then is $7,064.78 ($14,129.55/2). The Keogh contribution base is thus $100,000 less $7,064.78, or $92,935.23. If the nominal plan contribution rate is 25%, the net contribution rate is 20%. This rate is applied to the Keogh contribution base and results in a contribution of $18,587.05. (Note that this amount is 25% of "earned income," which is equal to $74,348.18 (i.e., the Keogh contribution base of $92,935.23 less the Keogh contribution of $18,587.05).)
The IRS table of "net" contribution rates is as follows:
Self-Employed Person's Rate Table Column A Column B If the Plan Contribution The Self-Employed Rate is: Person's Rate is: (shown as a %) (shown as a decimal) 1 .009901 2 .019608 3 .029126 4 .038462 5 .047619 6 .056604 7 .065421 8 .074074 9 .082569 10 .090909 11 .099099 12 .107143 13 .115044 14 .122807 15 .130435 16 .137931 17 .145299 18 .152542 19 .159664 20 .166667 21 .173554 22 .180328 23 .186992 24 .193548 25 .200000
Life insurance can be used as an incidental benefit in a plan covering self-employed individuals, but the tax treatment for the self-employed individuals is different from that applicable to regular employees in a qualified plan.
The entire cost of life insurance for regular employees is deductible as a plan contribution. Employees then pick up the value of the pure life insurance element as extra taxable compensation valued under Table 2001 (formerly the P.S. 58 table). (10) For details, see Chapter 13.
By contrast, for a self-employed individual, the pure life insurance element of an insurance premium is not deductible. (11) Only the portion of the premium that exceeds the pure protection value of the insurance is deductible. The pure protection value of the insurance is determined using Table 2001. Since all income and deductions flow automatically to the owners in an unincorporated business, the nondeductible life insurance element in effect becomes additional taxable income to the self-employed individual.
Example: Leo, a self-employed individual, has a Keogh plan providing incidental insurance through a cash value life insurance contract. This year's premium is $3,000, of which $1,200 is for pure life insurance protection and the remainder is used to increase the cash value. Leo can deduct $1,800 of the premium as a plan contribution. The remaining $1,200 is nondeductible. Leo therefore must pay tax on the $1,200 used for pure life insurance protection.
Another difference in the treatment of life insurance arises when benefits are paid from the plan. Regular employees have a "cost basis" (a nontaxable recovery element) in a plan equal to any Table 2001 costs they have included in income in the past, so long as the plan distribution is made from the same life insurance contract on which the costs were paid (see Chapter 13). For a self-employed individual, however, Table 2001 costs, while effectively included in income since they were nondeductible, are not includable in cost basis. (12)
TAX AND ERISA IMPLICATIONS
Except for the differences described just above, Keogh plans generally have the same tax and ERISA implications as regular qualified plans. For example, see Chapter 17 for the tax treatment of profit sharing plans.
The annual reporting requirement for qualified plans is simplified for many Keogh plans and other small plans. If a plan covers only the business owner or partners, or the owner or partners and their spouses, the reporting requirement is satisfied by filing Form 5500-EZ. A sample Form 5500-EZ can be found at: http://pro.nuco.com/booksupplements/TTEB.
1. The disadvantages, if any, of Keogh status of any qualified plan can be eliminated if the business owner incorporates the business and adopts a corporate plan. The owner is then a shareholder and employee of the corporation. Generally, under current law, it is not advantageous to incorporate a business simply to obtain corporate treatment for qualified plans. Incorporation may result in higher taxes overall and the advantages of corporate plans over Keogh plans are minimal in most cases.
2. A simplified employee pension (SEP) or SIMPLE IRA may be even simpler to adopt than a Keogh plan, particularly if only one self-employed individual is covered. In addition, SEPs can be adopted as late as the individual's tax return filing date, when it is too late to adopt a new Keogh plan. See Chapter 23 for more discussion of SEPs, and Chapter 24 for an explanation of SIMPLE IRAs.
3. Tax deductible IRA contributions may be available if the individual (or his spouse) is not an active participant in a qualified plan. The deduction is subject to cutbacks based on adjusted gross income if the individual (or his spouse) is an active participant in a qualified plan (see Chapter 6). Roth IRAs are also subject to the same limits (see Chapter 5). Because of these limitations, a Keogh plan often permits much greater levels of tax-deferred savings.
HOW TO INSTALL A PLAN
A Keogh plan follows the installation procedure for qualified plans described in Chapter 10. However, in adopting a Keogh plan, it is common to use a "prototype" plan designed by a bank, insurance company, mutual fund, or other financial institution. With a prototype, the sponsoring institution does most of the paperwork involved in installing the plan, at low or nominal cost to the self-employed individual. In return, the self-employed individual must keep most or all of the plan funds invested with that institution.
WHERE CAN I FIND OUT MORE ABOUT IT?
1. Banks, insurance companies, and other financial institutions actively market Keogh plans and will usually provide extensive information about their services.
2. IRS Publication 560, Self-Employed Retirement Plans, covers Keogh plans in detail. It is revised annually and available free from the IRS.
3. Tax Facts on Insurance & Employee Benefits, Cincinnati, OH, The National Underwriter Co. (revised annually).
QUESTIONS AND ANSWERS
Question--Who can establish a Keogh retirement plan?
Answer--Any sole proprietor or partnership, whether or not the business has employees-for example, doctors, lawyers, accountants, writers, etc. Generally, employees of the business must be included as participants in the plan on the same general basis as the key employees.
Question--Can I collect benefits if I become disabled?
Answer--In the event that any participant in the plan becomes so disabled as to render him or her unable to engage in any substantial gainful activity, all contributed amounts plus earnings may be paid immediately without being subject to a premature distribution penalty.
Question--What happens to my plan if I die?
Answer--In the event that any participant dies, all contributed amounts plus earnings may be immediately paid to the participant's designated beneficiary or estate.
Question--May I set up a Keogh plan in addition to an IRA?
Answer--Yes. If you are eligible to set up a Keogh plan you may also create a traditional or Roth IRA as well. However, because you are an active participant in the Keogh plan, traditional IRA contributions will not be tax deductible if your income is above certain limits (see Chapter 6).
A plan may also permit employees to make voluntary contributions to a "deemed IRA" established under the plan. Amounts so contributed reduce the limit for other traditional or Roth IRA contributions. See Chapter 13 for details.
Question--Can a Keogh plan be established if the self-employed person is covered under a corporate retirement plan of an employer?
Answer--Yes. An individual who works for a regular employer, and is covered under that employer's qualified plan, can establish a separate Keogh plan for an additional business carried on separately as a self-employed individual. For example, an engineering professor at a university may have additional income earned as a consulting engineer for outside clients. A Keogh plan will shelter some of that income from taxation and provide increased retirement savings on a tax-favored basis. The deduction limits for Keogh contributions are not affected unless the individual also controls or owns the regular employer.
For example, suppose an engineer earns $60,000 this year from his university position and is covered under the university's qualified pension plan. The engineer earns an additional $40,000 in consulting fees from outside clients. If he adopts a Keogh money purchase plan for this year, he can contribute and deduct up to 25% of earned income (see discussion above) to the Keogh plan.
Question--Can a Keogh plan fund be reached by the owner's creditors?
Answer--In general, assets in a qualified plan may have protection under federal law against diversion for any purpose other than providing benefits for the plan participant and his or her beneficiary, including an ERISA prohibition against "assignment or alienation" of benefits. (13) This can protect pension assets from creditors, (14) and even spouses have only the limited rights provided under the qualified domestic relations order (QDRO) provisions (see Chapter 8).
(1.) See IRC Section 4975(f)(6).
(2.) IRC Section 404(a)(3)(A).
(3.) Treas. Reg. [section]1.401-1(b)(2).
(4.) IRC Section 401(a)(17).
(5.) IRC Section 415(c)(1).
(6.) IRC Section 402(g)(8).
(7.) IRC Section 404(a)(3)(A)(v) was amended by EGTRRA 2001 to clarify that a money purchase plan will be treated in the same manner as a profit sharing plan for purposes of the deduction limit.
(8.) IRC Section 401(c)(2).
(9.) GCM 39807.
(10.) Notice 2002-8, 2002-1 CB 398.
(11.) IRC Section 404(e); Treas. Reg. [section]1.404(e)-1A(g).
(12.) Treas. Reg. [section]1.72-16(b)(4).
(13.) IRC Sections 401(a)(1), 401(a)(13); ERISA Section 206(d)(1).
(14.) The U.S. Supreme Court held that assets in a plan that is qualified under section 401(a) of the Internal Revenue Code and subject to Title I of ERISA (including the anti-alienation requirements of Section 206(d)(1)) are protected in bankruptcy. Patterson v. Shumate, 112 S. Ct. 1662 (1992). However, it is important to note that Keogh plans that cover only sole owners or partners (and their spouses) are not considered to cover "employees" within the meaning of Title I of ERISA (see Labor Reg. [section]2510.3-3) and, thus, are not subject to Title I of ERISA. A line of cases holds that such "plans without employees" are not protected by Patterson. See, e.g., In the Matter of Branch, 1994 U.S. App. Lexis 2870 (7th Cir. 1994) (unpublished opinion); In re Hall, 151 Bankr. 412 (Bankr. W.D. Mich. 1993); In re Witwer, 148 Bankr. 930 (Bankr. C.D. Cal. 1992), aff'd without opinion, 163 Bankr. 614 (9th Cir. BAP 1994); In re Lane, 149 Bankr. 760 (Bankr. E.D.N.Y. 1993).
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|Title Annotation:||Other Employer Retirement Plans|
|Publication:||Tools & Techniques of Employee Benefit and Retirement Planning, 11th ed.|
|Date:||Jan 1, 2009|
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