What is a Keogh Plan?

Keogh Plan

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Keogh Plan

A Keogh plan, also known as an HR-10 plan, is a tax-advantaged pension plan available in the United States for self-employed individuals or unincorporated businesses, such as sole proprietorships or partnerships. Named after U.S. Congressman Eugene Keogh, who sponsored the legislation creating the plan, Keogh plans can provide significant retirement savings benefits.

There are two main types of Keogh plans:

  • Defined-Benefit Plan: This works like a traditional pension plan, providing a fixed, pre-established benefit for employees at retirement. The amount you can contribute can be higher than other retirement accounts, but it requires an actuarial calculation to determine the annual contribution.
  • Defined-Contribution Plan: This could take the form of a profit-sharing plan where contributions are made based on a percentage of annual earnings, or a money purchase plan where a fixed percentage of income must be contributed each year.

Keogh plans are more complex than other types of retirement plans, such as IRAs or 401(k)s, and may require higher administrative fees because of IRS reporting requirements. However, they can allow for higher contribution limits, making them a potentially attractive option for self-employed individuals or business owners who wish to save more for retirement.

It’s worth noting that the term “Keogh plan” has largely been replaced in common usage by the term “Qualified Retirement Plan.” Before deciding to establish such a plan, one should consult with a financial advisor or accountant to understand the current regulations, limits, and tax implications.

Example of a Keogh Plan

Let’s take an example of a self-employed consultant named Sarah to illustrate how a Keogh plan might work.

Sarah runs a successful consulting business and her net earnings for the year are $120,000. She doesn’t have any employees and wants to save as much as possible for her retirement.

Sarah decides to set up a defined-contribution Keogh plan in the form of a profit-sharing plan, which allows her to contribute up to 25% of her net earnings (up to a specified limit, which as of 2021 was $58,000 but is subject to change).

Let’s assume the limit has not changed. Here’s how it would work:

  • Calculating Net Earnings: First, Sarah has to calculate her net earnings from self-employment, which involves subtracting half of her self-employment tax from her net profit. Assuming her self-employment tax is $15,000, her net earnings would be: $120,000 – $7,500 = $112,500.
  • Calculating Contribution: Sarah can contribute 25% of her net earnings to her Keogh plan. So, her maximum contribution would be: 25% * $112,500 = $28,125.

So, Sarah could contribute $28,125 into her Keogh plan for the year, which would be tax-deductible. Her contribution would then grow tax-deferred until retirement, at which point withdrawals would be taxed as ordinary income.

Note: This is a simplified example and the actual calculations could be more complex, depending on Sarah’s specific circumstances. Therefore, it’s always a good idea to consult with a financial advisor or tax professional when setting up and contributing to a retirement plan like a Keogh plan.

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