Retirement Plans for the Self-Employed

When contemplating retirement plans for their business, the self-employed have two popular options; the Simplified Employee Pension Plan (the “SEP”) and a Keogh Plan.  The Keogh Plan may be set-up as a profit-sharing plan or a money-purchase plan.  Depending upon the circumstances of the business owner, each of the Plans has significant benefits over the other.  I will try to highlight what I feel are some of the key difference for each of the Plans.

Plan Set-up:  A SEP is generally one of the easiest retirement plans to set-up.  It can be done as simply as through your bank or brokerage house, with separate accounts for each participant.  A model SEP can be established by using IRS Form 5305-SEP.  Setting up and administering a Keogh Plan is a little more complicated than a SEP and in most cases returns may have to be filed periodically (generally through a third-party administer).

An advantage of the SEP is it can be set up and funded by the tax return due date. If a business owner determines in January, for example, that a contribution to a SEP would benefit them on their prior year tax return, they may still set up and fund one before the filing of their return.  Contributions can be made after year-end to a Keogh plan only if the plan was actually set up by the end of the previous tax year.

Contribution and Deduction Limitations: With either plan, contributions may not be based on earnings in excess of $245,000 (for 2011, indexed for inflation) per year.  For the self-employed, the money purchase Keogh will generally allow for the largest deductible contributions possible.  Under this type of Keogh the owner may contribute 100% of their earnings, up to $49,000 (for 2011, indexed for inflation).  The profit-sharing Keogh and SEP Plan allow for employer contributions at a lower percentage.  A major disadvantage of the money-purchase plan is that the employer contributions are at a set amount for each of the years of the Plan.  The other Plans discussed, however, allow contributions to vary from one year to the next, depending upon how the business is doing.  The profit-sharing Keogh is a very popular option for high earners looking to maximize their employer contribution.

Employees Covered: If your employees are age 21 or older, they are generally accepted under most plans.  With a Keogh however, employees who have not completed one year of service (two years in some cases) do not have to be covered under the Plan.  Part-timers may not be covered at all based upon how a year of service is defined within the Plan documents.  The SEP rules differ from the Keogh in that covered employees include those who have worked for the company during three of the past five years.

Vesting Benefits: An employer may set up a Keogh so that the participants of the Plan are not entitled to their accrued benefits until they have been Plan members for a certain period of years (generally 3-5 years).  Alternatively, they may be entitled to their benefits gradually over a set period of time.  If the employee leaves the company, he or she is only entitled to their “vested” benefits.  SEP participants on the other hand are immediately vested in their benefits as no such waiting period is allowed.

As you can see, there are many differences to each of the Plans.  It is important for self-employed individuals to consult with their advisors before selecting a Plan to determine which Plan will give them the most benefit.  The business owner should work closely with their tax advisor to be certain they are in compliance with the Plan documents and have met required contribution deadlines.

Please feel free to contact us with any questions regarding the above, or if you would like further information regarding retirement plans or other business and tax related matters.

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