We all dream of a great retirement, but it is harder to achieve when you’re on your own for retirement savings.
More Americans are leaving traditional jobs. According to a Gallup survey, 34% of workers are self-employed. Setting up a retirement account is one of the biggest challenges for the self-employed. A 2019 study by Transamerica showed Americans don’t save enough.
It’s challenging to know how to save for retirement when you’re going it alone, and one option that doesn’t garner as much attention as 401(k) plans is a Keogh plan.
What Is a Keogh Plan?
The Keogh plan was crafted in 1962 by New York Rep. Eugene Keogh (pronounced KEE-oh), who established the Self-Employed Individuals Tax Retirement Act of 1962. It was the first program dedicated to helping self-employed individuals save for retirement and offering tax advantages.
A Keogh plan is a tax-deferred pension plan for high-earning self-employed individuals. This was the only way for self-employed individuals to save for retirement until the Economic Growth and Tax Relief Reconciliation Act of 2001 allowed other programs, such as IRAs, to apply to self-employed taxpayers.
Today, the Internal Revenue Service (IRS) has decided the term is officially outdated and refers to these plans as qualified retirement plans or “H.R. 10.” But many still call them Keogh plans.
A Keogh plan is similar to an IRA or 401(k) and can include mutual funds, stocks, bonds, and certificates of deposit. The good news is these contributions, similar to a 401(k) plan, are tax-deductible up to a certain percentage of a person’s income. But limits change annually based on the IRS.
Types of Keogh Plans
You can set up Keogh plans as defined benefit plans or defined contribution plans.
Defined Benefit Plans
If you like the idea of having a specific income in retirement, then consider a defined benefit plan. This is similar to a pension plan where retirees get the same payment each month in retirement.
You decide how much money you’d like to receive in retirement. Let’s say you want to get $1,000 per month. Then, you need to determine how much you’ll need to save per year to fund that goal and when you intend to retire.
A Keogh plan set up as a defined benefit plan will pay out a fixed income, much like a traditional pension plan.
Defined Contribution Plans
The most common type of Keogh plan is a defined contribution plan. This doesn’t guarantee a specific income in retirement, but it allows you to contribute a certain amount of your salary to your plan.
You can consider several defined contribution plans, such as a profit-sharing plan, where your business pays into the fund. Or, you use a strategy called money purchasing, where you contribute a fixed amount of money every year into the plan.
In retirement, you can draw from your Keogh plan the way you would from a traditional IRA or 401(k) plan.
How Does a Keogh Plan Work?
Only certain people can start a Keogh plan. You must be self-employed or be a sole-proprietorship. If you are a partnership or a limited liability company, you might also be eligible, but meet with an accountant to double check.
You can open your account at just about any bank, brokerage, or mutual fund company. The money to fund your account can be taken immediately out of your paycheck regularly, pretax.
You can invest the money in a wide range of assets such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs).
A Keogh Plan works similar to other retirement accounts, such as a 401(k) plan. You contribute pretax dollars and the contributions are tax-deductible. Your interest, dividends, and capital gains earned in your Keogh accounts will grow without you paying any taxes until you’re ready to withdraw. But you will pay taxes when you retire and start to withdraw money.
Keogh Plan Contribution Limits
Keogh plans are excellent because of their tremendous contribution limits, and they help high-earning self-employed individuals catch up on retirement savings.
For instance, if you set up a defined contribution plan, you can contribute up to 25% of your compensation or $61,000 in 2022. If you are age 50 or older, you are given a “catch-up” provision and can contribute up to $67,500 in 2022.
But if you want to set up a defined benefit plan, where you will receive a set amount each month in retirement, you can contribute much more. The sky’s nearly the limit in terms of contributions.
The IRS allows you to contribute up to $245,000 for 2022. All your contributions to your Keogh plan are pretax. If you earned $345,000 and contributed $245,000, then you’d only be taxed on an income of $100,000.
For high-income earners, this reduces your taxable income significantly. Self-employed individuals operate their own business and work for themselves rather than someone else.
Keogh Plan Withdrawal Rules
Withdrawal rates for Keogh Plans are similar to those of 401(k) plans. You can’t withdraw until you are age 59 ½. If you take money out beforehand, you will be penalized 10% for early distributions and may even have to pay additional fees from your state.
A Keogh plan has strict rules regarding hardships, and the IRS states hardship withdrawals are not allowed.
Once you are 59 ½, you can withdraw money with no penalties. But you aren’t required to start taking money out until age 70 ½.
Advantages of a Keogh Plan
The Keogh plans allow investors to make enormous contributions tax-free and could help older investors who got behind in their savings catch up dramatically.
- Significant Contributions: The contribution limits in Keogh plans are so much higher than other retirement vehicles like IRAs. This benefits older and high-income individuals looking to catch up on retirement savings. For example, contributions in a defined contribution Keogh plan can be $61,000 in 2022, but IRA contributions are limited to just $6,000.
- Tax-Deductible Contributions: For high-income earners, it’s a considerable advantage to lower your taxable income by contributing to your retirement account. This can allow you to reduce your tax bill significantly, set aside more money for retirement, and potentially earn better returns.
- Endless Investment Options: If you’re in a 401(k) plan, you can only invest in the fund choices your company has made available. But in this plan, you can select investments of your choosing.
- Perfect Chance to Catch Up: If you’re like many Americans and behind in your retirement savings, you can set up a Keogh plan and other retirement accounts such as an IRA. This allows you to get caught up on saving for retirement.
Disadvantages of a Keogh Plan
The challenges with the Keogh plan are it is quite nuanced and available to a select few people, and you must file an annual report to the IRS outlining how your fund is operated, which can be pretty arduous.
- Must Be Self Employed: This plan is available to a select number of people. You must be self-employed to qualify for a Keogh plan, and anyone who is an employee isn’t eligible for this program. Self-employment means paying your health insurance and Social Security.
- Lots of Red Tape: Setting up a Keogh plan for your business requires paperwork and administrative burden. You must submit a plan to the government, and the IRS requires specifics about the investments and strategies involved. You could be hit with stiff penalties if the form is not completed annually.
- Expensive to Operate: Given the amount of paperwork required to operate this plan efficiently, you need to seriously consider hiring a professional administrator, such as an attorney or an accountant. There are many details you must include in your plan.
- IRS Audits These Plans: You must update your plan document as the tax code changes, which can happen. And the IRS audits these plans, so you want to ensure your plan is always compliant with the most recent tax changes.
The Keogh plan does not get the same amount of attention in the media because it has more administrative burdens than more straightforward retirement plans such as a Roth IRA or traditional IRA.
But this plan is something you must consider if you’re self-employed, a sole proprietor, or a small-business owner because of the high contribution limits. If you’re earning a good income and have extra money for savings, consider this option as part of your financial plan.