available to a self-employed individual vary from the very fundamental
to the complex variety, which require the services of professional pension
Among the plans available are the Keogh, SEP, and
Defined Benefit and Simple IRA plans. Because of their complexity and
normally high administration costs, the Defined Benefit and Simple IRA
plans are not discussed in this article. However, older individuals should
take note of the larger retirement contributions available with Defined
Benefit plans which could justify the higher administration costs.
A Keogh plan can be a Money Purchase or Profit Sharing plan or a combination
of the two as explained later. The overall annual contribution limit
to a Keogh plan is 25% of the net profits less the retirement contribution
made by the plan itself. After doing the appropriate math, we find 25%
of the net profits less the retirement contribution actually equates to
20% of the net profit. The total contribution for the year is also limited
to $40,000 and the maximum compensation upon which the contribution is
based is limited to $200,000 (’03 rate, this contribution limit may be
for inflation annually.)
Based on net profit after deducting plan contribution.
As illustrated above
the Profit Sharing plan has the lower limit on contributions, but the
contribution is discretionary. On the other hand, a Money Purchase plan
provides a higher limit but contributions to the plan are mandatory each
year. The percentage limits for either the Profit Sharing plan or the
Money Purchase plan can be set at a lower limit when the plan is established.
When an employer wishes to limit the mandatory contribution limit of a
Money Purchase plan and at the same time maximize the annual contribution
limit, combination plans can be established.
Keogh plans must be
established before the end of the year for which a contribution is made.
However, the contribution for any year can be delayed until later, but
not later than the due date of the taxpayer’s individual return including
extension. Reporting requirements for one participant with Keogh plans
require that form(s) 5500-EZ be filed for the year the plan assets reach
$100,000 and every year thereafter so long as the plan is in existence.
All other plans must file form(s) 5500 annually. For calendar year taxpayers,
the due date for this report is July 31.
Unlike the Keogh plans, a SEP plan can be established after the end of
the close of the tax year. However, it must be established and funded
by the due date of the taxpayer’s return plus extensions. SEP plans are
also referred to as SEP IRAs since they utilize IRA accounts as the depository
for the plan contribution. Even though the funds are being deposited
into an IRA account, the SEP contribution is based on 20% of the
net profits from the self- employed business. An additional advantage
of a SEP plan is there is no annual reporting requirements like those
that apply to the Keogh plans.
If a self-employed individual has employees it may be necessary to include
the employees in the plan. Most plans require coverage once an employee
attains age 21. With a Keogh plan, you don't have to cover employees until
they have completed at least one year of service (two years in some cases).
A SEP is a little different since you only need to cover employees who
have worked for you during three of the past five years. Once this test
is met, most part time workers will have to be covered under a SEP.