A Keogh plan, also known as a HR10 plan, is a tax-deferred retirement plan designed for self-employed individuals and their employees. Contributions to the plan are deducted from gross income, giving the participant the benefit of a reduction in pre-tax income (this applies only for plan that are defined as an elective deferral plan).

Additional benefits include:

• contribution limits higher than those of IRAs
• contributions that are tax deferred until withdrawn
• certain lump sum benefits which are eligible for 10-year averaging,
• deferred interest income

A huge benefit for the owner of the business is that they are able to deduct the entire yearly Keogh contribution for themselves as well as those made for their employees.

The Keogh plan requires that the contributions be made in cash. Vested assets are held in trust for employees and can be rolled over into an IRA if the employee leaves the business.

Plan Types

There are two types of Keogh plans: Defined Contribution Plans and Defined Benefit Plans.

Defined Contribution Plans

In a defined contribution plan, the participant defines how much they want to contribute on a yearly basis.

There are two ways in which an employer may contribute to a defined contribution plan: a Money Purchase Plan or a Profit Sharing Plan. For a money purchase plan, a set contribution is made every year, regardless of the company's profits or losses. With the profit sharing plan, the contribution is dependent upon the profits of the business. Contributions are determined by a formula to allocate the overall contribution and distribution of accumulated funds after the retirement age. One advantage of this type of plan for owners is that the law allows for missing contributions during lean years.

Employees can contribute to both types of defined contribution plan in the same year and the amounts can vary each year. This plan has a limit of 25% of the participant's income or $40,000, whichever is less.

However, with this type of plan, there is no way to know how much it will ultimately give upon retiring. The amount contributed is fixed, but the benefit is not.

Defined Benefit Plans

In the defined benefit plan, the participant specifies how much they want to withdraw upon retirement. Using this number, a formula is used to calculate the percentage contributed based on the amount desired, the life expectancy of the participant, and number of years left to contribute before retirement.

Unless the plans are defined as an elective deferral plan, the contributions are not tax deductible. Contributions and earnings can grow tax-deferred until withdrawal.

Payment Distributions

Withdrawals from the plan cannot begin until the participant is 59 years of age and retired.

There are two options for payment distributions: monthly payouts or a single lump sum payout. Monthly distributions are taxed as ordinary income for each year received. For lump sum distributions, 20% of the amount is reported each year for five years.