A Keogh is similar to a 401(k) for very small businesses, but the annual contribution limits are higher than 401(k) limits. Keogh plans get their name from the man who created them, Eugene Keogh, who established the Self-Employed Individuals Tax Retirement Act of 1962, aka the Keogh Act. The plans were changed with a different act, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. They have changed so much, the IRS code no longer refers to them with the term "Keogh" (they are now HR 10 plans or qualified plans). The structures still exist, but they have lost popularity compared to plans like the SEP IRA or individual or solo 401(k). A Keogh may be right for a highly paid professional, such as a self-employed dentist or lawyer. But the cases in which these plans make sense over the alternatives are specific and fairly rare.Two Types of Keogh Plans
There are two types of Keoghs: defined contribution and defined benefit.
- Defined contribution: You define the contribution that will be made each year. You can do this in two ways: profit-sharing or money purchase. With profit-sharing you can contribute up to up to a $50,000 limit in 2012, and can deduct up to 25% of income. What you choose to contribute to a profit-sharing plan can change each year. With a money purchase plan, you determine at the outset the percentage of profits that will be placed in the Keogh. But that contribution is required if there are profits, and can't be changed. If the contribution isn't made, you will face a penalty.
- Defined benefit: This works like a traditional pension. You set a pension goal for yourself and fund it. You can contribute up to $200,000 for 2012, or 100% of compensation. This makes it an interesting choice for highly compensated self-employed individuals who want to contribute some extra dollars before retirement.
Contributions made to each type of plan are made on a pre-tax basis, meaning they are taken out of your taxable salary or you can take an upfront deduction on your annual income tax return.Investing in a Keogh
As with a traditional 401(k), the money contributed to a Keogh can be invested tax-deferred until retirement beginning at age 59 1/2 and no later than age 70. Withdrawals made before that time will be taxed on a federal and possibly state and local income level, plus you'll pay a 10% penalty fee. There are some exceptions to these rules, depending on your physical and financial health.
The money in a Keogh plan can be invested in stocks, bonds, mutual funds and other types of investments.
A Keogh plan must be established before the end of the year in which you wish to receive the deduction. But you can make Keogh contributions for the prior year when you file your tax returns by mid-April or (if you file an extension) mid-October.
Keogh plans require a good deal of annual paperwork. An IRS Form 5500 must be filed annually, and it requires the help of a tax accountant or financial professional. This is one of the primary reasons Keoghs can be complicated for the average self-employed individual. Talk to a financial or tax advisor before establishing a Keogh plan.
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