This article is part of a series on self-employed retirement plans, and was written by Robert D. Flach. Robert has been preparing business and individual tax returns for people in all walks of life since 1972. He writes the tax blogs THE WANDERING TAX PRO and the NJ TAX PRACTICE BLOG.
Article assumptions: Self-employed individuals have many types of retirement plans from which to choose. While these plans are available regardless of the type of business “entity” chosen, I will be discussing them from the point of view of the Schedule C filer. In such a situation the determination of the amount of the allowable contribution begins with the “net profit” reported on Line 31 of Schedule C or Line 3 of Schedule C-EZ.
All of the retirement plans that I will discuss are available to the one-man business with no employees, and I will limit my discussion to the contributions of the business owner. However these plans will require coverage of any qualifying W-2 employees of the business, and special rules will apply to contributions for employees.
The “grand-daddy” of retirement plans for the self-employed is the Keogh Plan, named for U.S. Representative Eugene James Keogh of New York. The Keogh plan was established by Congress in 1962 and expanded in the Economic Recovery Tax Act of 1981.
Defined Contribution and Defined Benefit Keogh Plans. There are two types of Keogh Plans – the Defined Contribution Plan and the Defined Benefit Plan. A Keogh Plan can consist of separate Defined Contribution and Defined Benefit components.
Contribution limits. The maximum contribution to a Defined Contribution Keogh Plan, like the SEP IRA, is 25% of compensation, up to $46,000 for 2008 and $49,000 for 2009. As with the SEP, this translates to 20% of the net profit from the business less the adjustment to income for 50% of self-employment tax.
Plan establishment and contribution deadlines. A Keogh Plan, whether Defined Contribution or Defined Benefit, must be established by December 31st of the first tax year the plan is to be effective. So there is still time to open a Keogh Plan for 2008. The actual contributions must be made by the due date of the Form 1040, including extensions.
Defined Contribution Keogh Plan
In a Defined Contribution Plan, the annual deduction is based on a percentage of compensation, like the SEP. For example, 10% or 20% of compensation. The retirement benefit is the accumulation of the monies that have been contributed to the plan and the accrued earnings thereon.
There are two types of Defined Contribution Keogh Plans – Money Purchase and Profit Sharing.
- Money Purchase Plan. A Money Purchase Plan requires mandatory annual contributions. The plan will state that 10% of compensation (or net profit from the business for the owner-employee) will be contributed each year. As long as the business shows a profit a contribution must be made for the owner-employee.
- Profit Sharing Plan. With a Profit Sharing Plan the annual contributions are discretionary. The business owner can decide each year if he/she will make a contribution. The plan could say that 10% of compensation will be contributed if the company so decides.
Most Keogh Plans contain both Money Purchase and Profit Sharing components, with a separate account for each component.
Defined Benefit Keogh Plan
A Defined Benefit Plan determines a fixed amount of benefit to be paid upon retirement, i.e. 75% of salary or a fixed amount like $60,000 per year, and determines the annual contribution by using an actuarial formula to calculate the amount required to provide that benefit. Assumptions are made for future earnings and life expectancy.
The Defined Benefit Plan is most attractive to the older “owner-employee” – over age 50. Because of the short time until retirement age large annual contributions are needed to provide the established benefit. It is possible that an older self-employed person would be required to contribute 80% to 100% of “compensation” to the plan.
Additional Keogh Plan considerations
Keogh Plan administrative requirements. Keogh Plans are required to file an annual Form 5500 or Form 5500-EZ with the Employee Benefits Security Administration of the US Department of Labor. For smaller one-person plans this is relatively inexpensive, but the more complicated the plan, especially in the case of a Deferred Benefit Plan, the greater the cost. Defined Benefit Plans require annual actuarial calculations.
Because of the additional paperwork and expense there is really no reason for a one-person business to have a Defined Contribution Keogh Plan. The same benefits will be provided by the SEP. The only reason for a one-man operation to have a Keogh is if it is a Defined Benefit Plan, assuming the business profits and additional tax benefit can justify the additional expense and paperwork.
Here is more information about Self-Employed Retirement Plans.