41.2 Choosing a Keogh Plan

You may set up a self-employed retirement plan called a Keogh plan if you have net earnings (gross business or professional income less allowable business deductions) from your sole proprietorship or partnership for which the plan is established. If you are an inactive owner, such as a limited partner, you do not qualify to set up a Keogh plan—unless you receive guaranteed payments for services that are treated as earnings from self-employment.

Set-up deadline.

To deduct contributions for a tax year, your Keogh plan must be adopted by the last day of that year (December 31 if you report on a calendar year basis). If it is, contributions can be made up to the due date of your return for that year, plus extensions.

Partnership plans.

An individual partner or partners, although self-employed, may not set up a Keogh plan. The plan must be established by the partnership. Partnership deductions for contributions to an individual partner’s account are reported on the partner’s Schedule K-1 (Form 1065) and deducted by the partner as an adjustment to income on Line 28 of Form 1040.

Including employees in your plan.

You must include in your plan all employees who have reached age 21 with at least one year of service. An employee may be required to complete two years of service before participating if your plan provides for full and immediate vesting after no more than two years. You generally are not required to cover seasonal or part-time employees who work less than 1,000 hours during a 12-month period.

A minimum coverage rule requires that a defined benefit plan must include at least 40% of all employees, or 50 employees if that is less.

Planning Reminder

One-Person 401(k) Plan

If you have no employees other than your spouse, you may want to consider a “one-person” 401(k) plan, which allows you to contribute more than a Keogh plan. For example, for 2012, elective deferrals of up to $17,000 could be made, or $22,500 if age 50 or older during the year. In addition to the deferrals, a contribution of up to 20% of net earnings (reduced by the employer equivalent portion of self-employment tax liability (41.4)) can be made to your account, subject to the overall limit, which for 2012 is $50,000, or $55,500 if age 50 or older. You can add a Roth 401(k) option to your plan, allowing after-tax contributions to produce tax-free returns. The income limitation on eligibility to contribute to a Roth IRA does not apply to a Roth 401(k). See the e-Supplement at jklasser.com for the 2013 overall limit.

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Your plan may not exclude employees who are over a certain age.

A plan may not discriminate in favor of officers or other highly compensated personnel. Benefits must be for the employees and their beneficiaries, and their plan rights may not be subject to forfeiture. A plan may not allow any of its funds to be diverted for purposes other than pension benefits. Contributions made on your behalf may not exceed the ratio of contributions made on behalf of employees.

Planning Reminder

Small Employer Credit for Retirement Plan Startup Costs

Employers with 100 or fewer employees that do not have a qualified retirement plan generally may claim a tax credit on Form 8881 for administrative costs of setting up a pension plan, profit-sharing plan, 401(k) plan, SEP, or SIMPLE plan. At least one non-highly-compensated employee must be covered. The maximum credit is $500, 50% of the first $1,000 of startup costs. The credit is allowed for costs incurred in the year in which the plan takes effect and in the next two years.

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There are two types of Keogh plans: defined-benefit plans and defined-contribution plans, and different rules apply to each. A defined-benefit plan provides in advance for a specific retirement benefit funded by quarterly contributions based on an IRS formula and actuarial assumptions. A defined-contribution plan does not fix a specific retirement benefit, but rather sets the amount of annual contributions so that the amount of retirement benefits depends on contributions and income earned on those contributions. If contributions are geared to profits, the plan is a profit-sharing plan. A plan that requires fixed contributions regardless of profits is a money-purchase plan. If you have a profit-sharing plan, a 401(k) plan arrangement can be included to allow you (and other participants) to make elective deferral contributions of before-tax compensation to the plan.

A defined-benefit plan may prove costly if you have older employees who also must be provided with proportionate defined benefits. Furthermore, a defined-benefit plan requires you to contribute to their accounts even if you do not have profits. For 2012, the benefit limit is the lesser of (a) 100% of the participant’s average compensation for the three consecutive years of highest compensation as an active participant or (b) $200,000. This dollar limit is reduced if benefits begin before age 62 and increased if benefits begin after age 65. The $200,000 limit is subject to cost-of-living increases; see the e-Supplement at jklasser.com for the 2013 limit.

For defined contribution plans, the 2012 limit on annual contributions and other additions (excluding earnings) was the lesser of 100% of compensation or $50,000. For 2013, the $50,000 limit may be adjusted for inflation; see the e-Supplement at jklasser.com .

Small employers (with 500 or fewer employees) can opt for a hybrid retirement plan, called a DB(k). It combines a 401(k)-like account with a small-employer-funded pension. Because the IRS had not issued guidance for financial institutions, they will likely become more available after guidance is available.