Small businesses can use retirement plans to reduce their tax burden, help fund retirement, shield assets and help recruit and retain employees. The options that exist depend on the business structure and the intended goal. For self-employed individuals and small-business owners two plans are often used: the Keogh and the Simplified Employee Plan IRA. Both the Keogh and the SEP-IRA offer compounded annual returns and an increase in value tax free until the assets are distributed. Which plan to choose for maximum benefit will depend upon whether you're self employed or a small business owner and how much money you make.
Self Employed Retirement Plans: Keogh Plan
The Keogh plan, also called an HR 10 plan, is a qualified retirement plan with use limited to self-employed individuals and small businesses operating as sole proprietorships or general partnerships. This includes single-member limited liability companies treated as disregarded entities for tax purposes. Keogh plans can be set up as defined benefit plans or defined contribution plans. Defined benefit plans–traditional pension plans–pay out a certain dollar amount per month in retirement. Defined contribution plans–like 401(k)s and 403(b)s–specify the monthly or annual contribution.
A Keogh offers two types of defined contribution plans: money purchase plans and profit sharing plans. The profit sharing plan option provides the most flexibility. The Keogh profit sharing plan allows the contribution percentage to vary from year to year. However, the Keogh money purchase plan option requires the business owner to set the contribution percentage when she establishes the plan. This percentage must be met each year; otherwise, the individual will be subject to a penalty in the year the percentage is not met.
Self Employed Retirement Plans: SEP-IRA
A SEP-IRA is a self employed IRA also available to small businesses, including corporations and limited partnerships, with employees. The SEP must be established by and for each and every eligible employee. The laws governing the SEP-IRA mandate that the contribution percentage be the same for all employees and that the company, not the employee, contributes the funds to the plan. The company does not have to make contributions every year.
Keogh and SEP Plans Compared
Both SEP-IRAs and Keoghs can be established at brokerage firms, banks or insurance companies and can invest in stocks, bonds, mutual funds, money market funds, CDs and annuities. Neither type of plan can invest in real estate.
Keoghs have more paperwork that requires professional administrative assistance and thus incurs a higher financial toll. If the defined benefit plan is elected, the complexity increases, but so do the contribution limits. All contributions to a SEP are completely tax deductible, but the Keogh has limitations for the defined contribution plan option. Because of these differences, highly compensated self-employed individuals typically prefer to use the Keogh plan, and small businesses with several employees prefer the SEP.
2018 Contribution Limits
For the 2018 tax year, the SEP-IRA has a maximum deductible contribution limit of the lesser of 25 percent of annual compensation or $55,000. The Keogh’s defined benefit plan option allows a contribution of the lesser of $220,000 or 100 percent of the participant's average compensation over the last three years; however, if the plan is a defined contribution plan, the limit is the lesser of $55,000 or 100 percent of the participant's compensation for the year.
For example, if you have a defined contribution Keogh plan and your compensation in 2018 was $100,000, your contribution limit for the year is $55,000. However, if you have a defined benefit plan, and your compensation was $100,000 in 2018, $120,000 in 2017 and $95,000 in 2016 (for a three-year average of $105,000), your contribution limit is $105,000.
If you have a SEP and you made $100,000 in 2018, your limit is $25,000, which is 25 percent of $100,000.
2017 Contribution Limits
The contribution limit in 2017 for the SEP was 25 percent of $54,000, and for the Keogh, the lesser of $215,000 or 100 percent of average three-year compensation for the defined benefit plan or the lesser of $54,000 or 100 percent of the participant's compensation for the year for the defined contribution plan.
Tiffany C. Wright has been writing since 2007. She is a business owner, interim CEO and author of "Solving the Capital Equation: Financing Solutions for Small Businesses." Wright has helped companies obtain more than $31 million in financing. She holds a master's degree in finance and entrepreneurial management from the Wharton School of the University of Pennsylvania.