Keogh Plans

Generally, a Keogh Plan is a defined benefit or a defined contribution retirement plan set up by a self-employed person or partnership. The plan must meet the same eligibility and coverage requirements, contribution limits, vesting requirements, rules for integration with Social Security, and other plan requirements, as any qualified retirement plan covering corporate employees.

If you have employees, they must be allowed to participate in the Keogh plan. Also, an individual who has another job during the day, but decides to supplement his or her income by turning a weekend avocation into a business, is eligible to open a Keogh plan based on the net earnings derived from the part-time self-employment.

Warning It's important to remember that to take a deduction for contributions to a Keogh plan on behalf of yourself, you must have some net earnings -- you cannot use Keogh plan contributions to create a business loss.

Qualified plans. These plans are those that meet the requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and the federal tax laws, and qualify for four significant tax benefits.

• The income generated by the plan assets is not subject to income tax, because the income is earned and managed within the framework of a tax-exempt trust.
• An employer is entitled to a current tax deduction for contributions to the plan.
• The plan participants (the employees or their beneficiaries) do not have to pay income tax on the amounts contributed on their behalf until the year the funds are distributed to them by the employer.
• Under the right circumstances, beneficiaries of qualified plan distributions are afforded special tax treatment.

Nonqualified plans. These types of plans do not meet ERISA guidelines and federal tax law requirements. They do not get all of the preferential tax treatment of qualified plans, but employers may still deduct contributions to these plans, generally at the time that employees become vested in the benefits. Nonqualified plans are usually designed to provide deferred compensation exclusively for one or more executives.

For more details, check out the following:

• requirements for qualified plans
• defined benefit plans
• defined contribution plans

Setting up a qualified plan. To qualify for tax deductions, a qualified plan must be in writing and must be communicated to the employees. Most plans follow a standard form (a master or prototype plan) approved by the Internal Revenue Service, and provided by the bank or financial services company that administers the plan. If you prefer, you can set up an individually designed plan to meet specific needs, but you will need the help of a professional in doing so. You can set up a trust or custodial account to invest the funds, or buy a contract from an insurance company.

Reporting contributions. Contributions made for employees to a qualified plan are reported on Line 19 of Schedule C, "Pension and profit-sharing plans." Contributions made on your own behalf would be reported on Line 28 of your Form 1040.

There are also reporting requirements with regard to the plan itself. Generally, an annual report on IRS Form 5500 must be filed with the IRS by the last day of the 7^th month after the close of the plan year. Single-participant plans can use Form 5500-EZ. If your one-participant plan (or plans) had total assets of $250,000 or less at the end of the plan year, then you do not have to file Form 5500-EZ for that plan year. All plans should file a Form 5500-EZ for the final plan year to show that all assets have been distributed. See the instructions for these forms (available from the IRS by calling 1-800-TAX-FORM, or at the IRS website) or see your professional tax advisor.