How Does a Keogh Plan Work?

Introduction

A Keogh plan is a personal retirement plan for small businesses and for those who are self employed. This tax-deferred plan is overseen by the 401(a) tax code allows workers to contribute a specific amount of money each year before taxes out of each check. A Keogh plan is a great alternative way to save for retirement if you do not work for a large corporation.

How it Works

Keogh plans work by allowing you to both receive a tax break for the money you put into the plan each year, as well as to gain interest tax free until the time in which you want to start taking money out of the Keogh account. Once you start drawing money from the account, you are responsible to pay the applicable taxes. The following people can open a Keogh retirement account: the self-employed, small business owners, schedule C Sole Proprietors, or those who have a string of self-employment income alongside a regular job.

Structure

There are two different structure for Keogh plans, profit sharing and money purchase. The profit sharing plan allows to change how much money you want to put in the plan each year dependent on how profitable your business is. If you have a less profitable year you can put in less. For a more profitable year you can put in more. A money purchase plan has a fixed contribution rate regardless of how profitable your year has been. You can change this rate by amending the plan document.

Contribution Limits

With a Keogh plan you are limited to 25 percent of what you make. However, this is 25 percent of your income after both regular taxes, as well as self employment taxes. Once the money is in the plan, it cannot be withdrawn without penalty until you are 59 1/2. If you withdraw money before that point you will be assessed a 10 percent penalty fee. Some plans allow for emergency or medical withdrawals. Check with the associate that is setting up your Keogh plan for additional information on withdrawal penalties.

Advantages

Since self employed individuals have much higher tax rates, a Keogh plan takes some of the tax burden off by deferring some of the tax until you withdraw your funds from the account. Because of bankruptcy laws, the money in the account is also protected from creditors. A Keogh plan also allows you to contribute much more money to the plan than any other retirement plan such as an IRA or 401(k).

Disadvantages

Like other retirement plans, there are penalty fees that come with withdrawing payments early. These fees can be much higher than those associated with a traditional retirement account. If your plan reaches above $100,000, you will have to file additional tax information on a 5500 form. Also, as part of the account, you have to file a vesting plan. This sets the length of time you have to wait before you can receive your benefits. This makes the plan rather inflexible to your needs if you need money earlier than what is stated on the vesting plan. A Keogh plan also requires significant upkeep. Any time that the tax code changes, you will be required to update the plan document. This can take a lot of work, and you may need additional assistance to complete the process.

Resources

• Additional Information on the Keogh Retirement Plan