Keogh Plan - Drawbacks

Drawbacks

Keogh Plans are not as common as most other retirement plans because there are several limitations to Keogh Plans.

Compared to other retirement plans (traditional IRA, SIMPLE IRA, etc.), Keogh Plans require more administrative paperwork. While most small business owners can manage to set up other plans themselves, a Keogh Plans requires complex calculations and professional help to establish.

Keogh Plans cannot be used for “self-employed” individuals who work in the capacity of an independent contractor. Keogh Plans are applicable to self-employed individuals who own their own business (with articles of incorporation, etc.).

All contributions must be made “pre-tax,” meaning that the contributions can be deducted from this year’s tax, but taxes must be paid on the money when it is withdrawn during retirement. There is no such thing as a “Roth Keogh Plan.”

Penalties may apply for making withdrawals from a Keogh Plan before you turn 59½.

The main benefit of a Keogh Plan vs. other plans (Keogh’s high contribution limit) is lost in individuals who do not make a high level of income. These individuals may get the same benefits of a Keogh Plan with less administrative cost by using another type of retirement plan (401k, SEP-IRA, etc.) This is best illustrated by comparing the following 3 scenarios:

Scenario #1 – A self-employed accountant makes $50,000 per year from her accounting business. Her maximum contribution is 25% of her post-contribution income ($10,000, which would be the same as saying 20% of her gross income), regardless of whether she uses a SEP-IRA, Keogh Plan, or SIMPLE 401(k). Since there are less administrative costs, she would benefit most from choosing either the SEP-IRA or SIMPLE 401(k).

Scenario #2 - A family physician who owns his own practice makes $100,000 per year. His maximum contribution is 25% of his post-contribution income ($20,000, which would be the same as saying 20% of his gross income) whether he uses a Keogh Plan or a SEP-IRA. The cost of maintaining the SEP-IRA is much less, so he would benefit more from that plan.

Scenario #3 – An entrepreneur who owns a small marketing firm makes $400,000 per year. She wishes to contribute as much as possible to a retirement plan in order to minimize her current taxes. She could contribute up to $11,500 for a SIMPLE IRA, $49,000 to a SEP-IRA, or up to $50,000 (contribution cap for 2012) in a Keogh Plan. By choosing the Keogh Plan over the SEP-IRA, she can contribute an additional $1,000 per year into her retirement plan. She can also contribute $5,000 into a traditional IRA.