hr 10 (keogh) retirement plan for the self-employed chapter 50 tools & techniques of estate...

HR 10 (Keogh) Retirement Plan for the Self-Employed

Chapter 50Tools & Techniques of

Estate Planning

Copyright 2011, The National Underwriter Company 1

• Under an HR-10 (Keogh) plan, a self-employed individual is allowed to take a tax deduction for money set aside to provide for retirement– Sole proprietor or partners with earned income

• A Keogh plan also is a means of providing retirement security for employees working for the self-employed individual

What Is An HR-10 (Keogh) Retirement Plan For The Self-Employed ?



Estate Planning


• When the self-employed individual would like to provide personal retirement funds

• When the self-employed individual would like to provide financial security for the retirement of employees

• When the self-employed individual would like to defer tax on otherwise currently taxable income

When Is Use Of A Keogh Appropriate?



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• Keogh eligibility rules are the same as those for corporate plans– Full time employees who are below age 21 or who have less

than one year of service may be excluded from coverage• A year of service means a 12-month period during which the

employee has worked at least 1,000 hours

– A plan may require two years of service if there is 100% immediate vesting for each participant

• Keogh must meet minimum participation, coverage and nondiscrimination rules applicable to corporate qualified plans

What Are The Requirements?



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• Keogh plans must meet minimum vesting standards applicable to corporate plans– Vesting refers to the nonforfeitability of employer

contributions for covered employees

• Full vesting is required after five years or seven years under an accelerated graduated vesting schedule

• Faster vesting is required for top-heavy plans and for the match portion of traditional 401(k) plans




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• Keogh must be in writing

– An individually drafted trust instrument

– “Master plan” a standardized form plan, with or without a trust, administered by an insurance company or bank acting as a funding medium for purposes of providing benefits on a standardized basis

– “Prototype plan” a standardized plan made available by the sponsoring organization for use, with or without change, by the self-employed individual who administers the plan




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• Keogh is not required to have an institutional trustee

• Owner-employee must make a contribution in order to bring the plan into being

• If all IRC Section 401(a) requirements are met, the Keogh plan will be “qualified” and enjoy the benefits of – Current deductions for contributions to the plan, and

– Deferred taxation of benefits until distribution




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Example:

– Self-employed client earns $80,000 per year in income

– Client has four full-time employees who all have more than one year of service and have attained age 21

– Two assistants earn $20,000 each and the two clerks earn $10,000 each, for a total of $60,000

How Is It Done?



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Example:– Client establishes a Keogh plan– Plan calls for contributions of 10% of his earned income to

be used to provide a pension for him and 10% of each employee’s earnings to provide for their retirements

– 10% of $60,000 = $6,000 contribution for employees– Client can deduct this entire amount– After making a contribution for the employees, client’s

earned income decreases to $74,000 and then contributions for himself will be deducted, along with other deductions such as ½ of his self-employment tax

How Is It Done?



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• Contributions made on behalf of an owner-employee to a Keogh are deductible from gross income on the owner-employee’s federal income tax return

• Deductible deposits made by an employer are not currently taxable either to the employer himself or to a participating employee– No tax will be paid until benefits are actually received

Tax Implications



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• Income earned by assets in the plan accumulates tax-free

• A lump-sum distribution receives basically the same tax treatment that a similar distribution would receive from a corporate-sponsored qualified plan

Tax Implications (cont’d)



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• Plan benefits are subject to estate tax to the same extent as any other asset

• Maximum contribution allowed to a “defined contribution” plan on behalf of a self-employed individual is limited to the lesser of

– 100% of earned income, or

– $49,000 (2011 indexed) known as the Section 415 annual additions limit

Tax Implications (cont’d)



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• Annual additions limit does not apply to “defined benefit” Keogh plans, which are subject to different limits based on the benefit promised by the plan

– For retirement at age 62 a defined benefit plan can be funded to provide an annual retirement income benefit of the lesser of

• 100% of the participant’s average compensation for his highest paid three years of participation, or

• $195,000 (2011 indexed)

– If benefits commence prior to age 62, the limit is reduced

Tax Implications



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• An owner-employee may make nondeductible voluntary contributions, in addition to deductible contributions

– All contributions are counted for purpose of annual additions, and

– Must conform to special nondiscrimination tests

Tax Implications



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• Deduction limits on contributions to Keogh plans depend on the type of plan

– Defined contribution plan

• Deductible amount is 25% of total compensation of plan participants (earned income for self-employed individuals)

– Defined benefit plan

• Deductible amount is the amount actuarially determined to be necessary to pay the benefits promised, not to exceed Section 415 limits

Tax Implications



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• There is a 10% annual nondeductible excise tax on “excess” contributions (above the Section 415 limits) made to the plan until the excess is eliminated, subject to certain exceptions

Tax Implications



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• A 10% penalty tax is imposed on distributions before the participant attains 59½, with exceptions for – Death– Disability– Divorce– Payments made over a participant’s life– Extraordinary medical expenses– In the case of a SIMPLE IRA the penalty is increased to 25%

during the first two years of participation

Tax Implications



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• Benefits accumulated in a Keogh plan for an employee who was married during participation in the plan, while a resident of a community property state belongs equally to the employee and employee’s spouse

• Spouses can change the normal effect of the laws by an agreement, such as a pre-nuptial agreement

Issues In Community Property States



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• When couples move from a common law state to a community property state a court may determine the community property portion on the basis of – Contributions made method (divide the benefits in the

proportion of contributions made after moving to the community property state, plus earnings, to the total amount in the plan) or

– Time method (divide the benefits on the basis of proportionate years of participation in the plan)

– The non-community property portion of the Keogh benefit would be the separate property of the employee

Issues In Community Property States



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Earned Income

• Contribution limits in a Keogh plan are based on “earned income” instead of on “compensation”

• “Earned income” means net earnings derived from self-employed individual’s business as result of personal efforts or personal service (as distinguished from investment income)



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Earned Income

• Earned income calculation requires calculation of adjusted net earnings-- gross earnings minus:

– all allowable business deductions

– allowable deductions under Coded sections 62 and 404 for qualified plan contributions, and

– deduction for ½ of self employed individual’s self employment tax



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Earned Income

• However, deduction for self-employed individual cannot be known until self-employed individual’s “earned income” is known.

• Interdependent variable formula is needed to determine the deductible contribution

• IRS requires self-employment tax deduction to be taken before determining the Keogh contribution



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Earned Income Example

• Self-employed individual’s net earnings: $64,970• Subtract 7.65% (one-half of self employment tax) =

$60,000• Multiply $60,000 by 20% to obtain maximum

contribution available on self employed individual’s behalf ($12,000)

• Result is same figure obtained by multiplying his earned income ($48,000) by 25%



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Plan Loans

• Plan loans may be made to a self employed person without being treated as a taxable distribution or prohibited transaction. Limits are same as for qualified plans:– 5-year term limit– $50,000 or one-half of nonforfeitable accrued benefit

($10,000 de minimis)– Reasonable rate of interest– Adequately secured, can’t favor HCEs– Reasonable repayment schedule



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Top Heavy Plans

• Most Keogh plans are top heavy

• Special additional requirements– Faster vesting: 3 year/100% or 6 year graded– Minimum benefit for nonkey employees—3% of

compensation in defined contribution plan, benefit of 2% of average compensation times years of service in defined benefit plan

• SIMPLE IRAs, SIMPLE 401(k) plans and safe harbor 401(k) plans generally exempt.

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