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Saving and planning for retirement can be complicated. As a small business owner, you’re probably painfully aware that you’re on your own in this department, and that some of the more well-known retirement plans are unavailable to you. Only a corporation can establish and administer an employer 401(k) plan or 403(b) plan, for instance; the same is true for a conventional pension.
Thankfully, there are alternative methods available to self-employed individuals for investing in their retirement. Individual retirement accounts, or IRAs, of all varieties are a good choice for both the employees and proprietors of small businesses. Traditional and Roth IRAs are accessible to corporate staff and entrepreneurs alike, while companies of any size can create a simplified employee pension (SEP) or a savings incentive match plan for employees (SIMPLE)—though they’re particularly useful for independent enterprises.
Another excellent option for small business owners is the solo 401(k) which operates just like a corporate 401(k) but exists solely for one person and their spouse—hence the name. However, there’s an additional possibility that entrepreneurs often overlook, and that’s the Keogh plan.
Named for its creator, Congressman Eugene Keogh, a Keogh plan is a type of retirement account for self-employed individuals and the owners of business entities like sole proprietorships, general partnerships, or limited liability corporations (LLCs). It is not available to freelance workers or independent contractors.
Like the savings plans discussed above, a Keogh plan is “qualified” by the Internal Revenue Service, which means it’s eligible for certain tax savings and that one can invest contributions to the plan into stocks, certificates of deposit (CDs), bonds, and annuities. As the IRS has altered the original structure of these plans significantly since their inception in 1962, Keogh plans are more commonly referred to these days as HR 10 plans.
A Keogh plan is similar to other qualified plans in that you don’t pay current taxes on the money you contribute to your account, which lowers your total tax burden each year you pay into the plan. Eventually, though, you’ll be taxed on this money, when you withdraw from the account during retirement. By that point, however, you might be in a lower tax bracket, as you’re no longer employed and make less money, and theoretically you will pay fewer taxes than you would have had you paid them on your contributions upfront.
As with any qualified account, you can withdraw money from a Keogh account without penalty as early as 59 and a half years old, and you must begin withdrawals by age 70 and a half.
If you choose to access your money before the proper time, in what is called an early distribution, you will pay current federal and state taxes at the time of withdrawal, plus a 10% penalty. There are a few exceptions to the rules against early distribution, for issues like large medical bills and disability.
There are several types of Keogh plans. We’ll discuss each one in turn.
Defined contribution Keogh plans are exactly as they sound. These are accounts in which you define the contribution that you’ll make each year to your plan. There are two types of defined contribution plans.
In 2017, the IRS authorized annual employee contributions up to $18,000 with a profit sharing plan, and a small business could contribute up to $54,000 of their profits. As these figures must be adjusted each year to account for cost of living increases, these limits rose to $18,500 for employees and $55,000 for an enterprise in 2018. And in 2019, the numbers are slated to sit at $19,000 for employees and $56,000 for a company. It’s unclear whether the IRS will continue this precise pattern of escalation in future years.
With a Keogh plan, an enterprise can also deduct up to 25% of their earnings from their current tax burden. With an earnings cap of $270,000 in 2017, this figure provided a maximum deduction of $67,500. In 2018, the earnings limit rose to $275,000 or a $68,750 deduction. And the total allowed earnings will increase to $280,000 in 2019, for a total deduction of $70,000. While this is excellent news for a small business with high revenue, a profit sharing plan allows an enterprise to contribute whatever amount it deems appropriate each year—whether that be a meager sum when times are tough or a substantial total when the company thrives.
Money purchase plans require that an enterprise contribute a predetermined amount per employee and/or a fixed percentage of its income to a Keogh account each year, and that number is decided in the founding documents for the business. If the company fails to make this contribution, they must pay a fee.
In the past, businesses chose this rigid option as opposed to the flexible profit sharing plan because the limits on both contributions and deductions were higher with this type of account. However, the IRS rescinded this incentive, and set the same maximums for money purchase plans as profit sharing plans. Thus, a small enterprise is likely to select this version of a Keogh account only if a board of directors or a lender demands it—as this choice provides certainty regarding Keogh contributions—and all authorities in business appreciate certainty.
Defined benefit plans are also just as their name implies: The business owner defines the benefit they wish to receive upon retirement, and works backward to determine the annual contribution required to achieve that amount. The contribution required and the deduction allowed to reach your benefit goal are complex to compute. An actuary uses variables like your age and expected return on investments to calculate this figure.
In 2017, the IRS set a cap of $215,000 as the maximum benefit to be received annually upon retirement. That figure rose to $220,000 in 2018, and the cap will sit at $225,000 for 2019. Once again, the pattern in the cost of living increase for the maximum annual benefit is noteworthy but is not a guarantee of future hikes.
The main reason that small business owners select a Keogh plan is that they have high contribution and deduction limits. These limits are based on percentages of net profit, however, which means that you’ve already deducted self-employment tax and contributions to employee retirement funds, so these amounts aren’t as attractive as they initially seem.
In addition, Keogh accounts are expensive to establish and to maintain. These plans require complicated IRS paperwork yearly and incur costly annual fees. To get it right, you need to enlist the assistance of an accountant or other tax professional.
If your business has any employees, the law requires that you allow them to participate in your Keogh plan. Unlike other qualified plans, however, the employer is the sole investor; the employee contributes nothing to the plan. While you can deduct from your own tax burden the contributions that you make to your Keogh account on your employees’ behalf, you’ll still foot their entire retirement bill.
Finally, if you create a Keogh account, your financial information becomes public record. Most small businesses aren’t ready to air their financial dirty laundry, and understandably so.
Thus, if you’re the sole employee of your company, you’re well-to-do, and you desire to save more money at a faster rate—perhaps because you plan to retire soon—the Keogh account is a good choice for you. For most individuals, however, the disadvantages of a Keogh plan outweigh the advantages—which is why you rarely see them discussed in retirement planning today.