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Keogh Plans

Keogh Plans
Although a Keogh plan is usually established by self-employed persons and businesses such as sole proprietorships and partnerships, it can also be established by a corporation. With a partnership, it is the partnership itself that must set up the plan (individual partners may not do so). A Keogh plan (often just referred to as a "Keogh" or "HR-10 plan") is a type of retirement plan where the employer, not the employee, makes contributions to benefit the employees. There are both defined contribution and defined benefit Keogh plans.

For income tax purposes, employer contributions for employees are not considered salary.

The contributions and earnings grow tax-deferred (income tax isn't due until distributions).

The general tax rules below are the federal income tax rules as of January 1, 2001) and may be subject to exceptions. Always check your state (and local) income tax rules on Keogh plans. Finally, since tax laws may (and probably will) change from time to time, always check with your tax advisor before making major decisions regarding your Keogh plans.

As a general rule, if any Keogh contributions are made, they must be made for all employees who:

1. are at least age 21 and
2. have completed one year of service with the employer (two years in some cases)
The term "year of service" means 1,000 hours of work.

Employers can include more employees by reducing these requirements.

Self-employed individuals need net earnings (not losses) from personal services (not investments) to make contributions for themselves.

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Contribution limits
Depending upon the type of plan(s) in effect, there are different limitations on contributions. In every case, the maximum compensation considered for employees is $170,000 in the year 2001).

If you are the owner or a partner of a business, there may be special rules that apply to you in calculating your allowable contribution.

Profit Sharing Plan
The annual contribution limit per employee is the lesser of:
1. 25% of compensation or
2. $35,000
Money Purchase Pension Plan
The contribution limit per employee is the lesser of:
1. 25% of compensation or
2. $35,000
For a self-employed participant, the 25% limit of compensation is actually about 20% of net earnings.

Defined Benefit Pension Plan
With a defined benefit plan, the normal retirement benefit being funded cannot exceed the lesser of:
1. an indexed amount ( $140,000 for the year 2001) or
2. 100% of a participant's average compensation for the three consecutive years of highest compensation.
There are other variables that can be built in such as reducing plan benefits by the amount of expected Social Security benefits (this reduces the cost of funding plan benefits and tends to favor the more highly compensated plan participants).

Your ownership of contributions made for you and the earnings on those contributions depends upon the vesting period set up in the Keogh plan. A plan must allow you to vest (or own) in one of these three ways:
1. 20% after 3 years of service and an additional 20% for each additional year of service (making you 100% vested within 7 years) or
2. No vested interest until after 5 years of service and then you are 100% vested (this method of vesting is known as "cliff vesting") or
3. A more liberal, faster vesting plan either selected by your employer or required by law in some cases.
Whenever you are considering job opportunities, it is a good idea to check the retirement plan vesting schedule.

Benefits of the Keogh Plan
1. Depending upon the type of plan(s), contributions may be:
a. up to the lesser of 25% of compensation or $35,000 or
b. providing for a normal retirement benefit up to the lesser of $135,000 or 100% of average compensation for three consecutive years of highest compensation
2. Contributions aren't considered part of an employee's salary for income tax purposes and can be deducted by employers.
3. Earnings and contributions grow tax-deferred without any reduction for income tax each year.
4. Contributions are generally only made by the employer.
5. You may be able to borrow from the plan
6. You may be able to delay the start of distributions beyond age 70 if you continue to work (and do not own more than 5% of the company).
7. Special creditor protection may be available.
Timing of Distributions
Generally, distributions are made to you once you reach age 65 or leave the company. It depends upon how the plan document is written. The plan may even provide for early retirement benefits.

Depending upon the plan, you must start taking distributions no later than by April 1 of the year after you reach age 70. However, if you want to delay distributions until you stop working after age 70 (and you do not own more than 5% of the company), you may be allowed to wait until April 1 of the year following retirement.

Income Taxes & Penalties
Distributions of earnings and employer contributions are usually subject to federal and state ordinary income tax (the federal rate is from 15% to 39.6%).

Penalties can apply in these cases:
1. Withdrawing too little once you reach age 70 can result in a 50% penalty.
2. Taking a distribution before you are age 59 is subject to a 10% penalty unless an exception applies (see exceptions to the early distribution penalty below).
Exceptions to the Early Distribution Penalty
Distributions of earnings or employer contributions before age 59 will be subject to a 10% penalty unless:
1. You separated from service (are no longer working for your employer) and the separation occurred on or after the calendar year in which you reached age 55 or
2. You are disabled or
3. Your beneficiaries are receiving distributions due to your death or
4. You are taking the distributions under an approved annuity formula or
5. You are paying medical expenses in excess of 7.5% of your adjusted gross income or
6. You make a qualifying rollover/transfer.
Beneficiary Designations
Legal and tax advice is useful when determining how to complete beneficiary designations. Properly completed designations can help save estate (death) tax, avoid probate, allow better income tax opportunities and avoid creditor claims on retirement assets.

Extra care needs to be taken in naming trusts as a beneficiary of most retirement assets in case of a death. Sometimes, naming trusts as a beneficiary can trigger income tax sooner than it would otherwise be owed and reduce the amount ultimately shielded from death tax.

Note that many plans require the participant's spouse to be the beneficiary, unless the spouse provides written permission for another beneficieary to be named.

Creditor Protection
Retirement plans and accounts may have special creditor protection under federal and/or state laws. Different types of plans and accounts may have varying degrees of protection. State protection rules may also vary from state to state.

If you convert from one type of plan to another (e.g., from a traditional IRA to a Roth IRA), you may be changing how much protection you have. This may be also be the case if you move to another new state where the new state rules are different.

Consulting with an attorney for guidance on the creditor protection issue may be helpful.

Estate and Death Taxes
Retirement assets are added to your other assets and may be subject to federal and/or state death (estate) tax. It depends upon the size of your overall estate and the estate planning done for you. Consult with your advisor about ways to defer or avoid estate tax.

For more information:
If you'd like more information about how diversified investment advisors can help you achieve your financial objectives through personalized wealth or retirement and risk management strategies, please contact us. We welcome the opportunity to discuss your unique needs and how we may best meet them.

This page (formatted for versions 10.0 and higher of Internet Explorer) is updated regularly so check in from time-to-time to see new articles and updates. You can click on any underlined words on each page to see a specific wealth management topic in the left margin of each page.

Charles M. Bloom, Registered Principal offers securities and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.

The information contained in this web site is neither an offer nor solicitation of any security or service.


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