Are Keogh Plan Contributions Tax Deductible?

Keogh plans are a retirement savings option for self-employed individuals and small business owners. Established by the Self-Employed Individuals Tax Retirement Act of 1962, they aimed to provide retirement planning opportunities similar to those for corporate employees. While the IRS now refers to them as “qualified plans” or “HR 10 plans,” “Keogh plan” remains widely recognized. They allow individuals earning income outside a traditional employer-employee relationship to build retirement savings.

Understanding Keogh Plans

A Keogh plan is a tax-deferred retirement plan designed for self-employed individuals and unincorporated businesses. This includes sole proprietors, partners, and independent contractors. Even those with a primary job who supplement income through part-time self-employment may establish a Keogh plan based on their net earnings from that self-employment.

Keogh plans come in two forms: Money Purchase Plans and Profit-Sharing Plans. Money Purchase Plans require a fixed percentage of income to be contributed annually, regardless of business profitability. Profit-Sharing Plans offer greater flexibility, allowing the owner to decide how much to contribute each year, including contributing nothing in years with low or no profits. Both are defined contribution plans, where the benefit depends on contributions and investment performance.

Keogh Plan Contributions

Contributions to Keogh plans are subject to annual IRS limits. For 2024, the maximum contribution to a defined contribution Keogh plan, such as a Money Purchase or Profit-Sharing Plan, is the lesser of 25% of compensation or $69,000. This limit applies to combined employer and, if applicable, employee contributions. Compensation for self-employed individuals is net earnings from self-employment, after deducting one-half of self-employment taxes and the Keogh contributions themselves.

Money Purchase Plans require a predetermined contribution rate, which must be adhered to annually. Failure to make the specified contribution in a profitable year could lead to penalties. Profit-Sharing Plans, in contrast, provide flexibility to vary contributions year-to-year or skip contributions entirely, if the plan document allows. This flexibility makes Profit-Sharing Keogh plans a popular choice for businesses with fluctuating income.

Tax Deductibility of Keogh Contributions

Contributions to a Keogh plan are generally tax-deductible. This deduction reduces the individual’s taxable income for the year contributions are made. The deduction is “above-the-line,” lowering adjusted gross income (AGI), which can affect other tax calculations and eligibility for certain credits or deductions.

For sole proprietors, contributions on their own behalf are reported as a deduction on Form 1040, Schedule 1, Line 15. Contributions for employees are deducted on Schedule C, Line 19. The maximum deductible amount is tied to the contribution limits, calculated based on a percentage of the individual’s net self-employment earnings.

Keogh contributions also reduce income subject to self-employment tax. This creates a dual tax benefit: lowering ordinary income for tax purposes, and reducing the base for self-employment taxes (Social Security and Medicare). However, net earnings from self-employment are required to claim a deduction; Keogh contributions cannot create a business loss.

Taxation of Keogh Distributions

Distributions from Keogh plans are generally taxed as ordinary income in the year received. This is because contributions were pre-tax, and earnings grew tax-deferred. Tax rules for Keogh plan distributions are similar to other qualified retirement plans like 401(k)s and traditional IRAs.

Withdrawals before age 59½ are usually subject to a 10% early withdrawal penalty, plus ordinary income tax. Exceptions exist for disability, certain unreimbursed medical expenses, or separation from service at or after age 55. Even with an exception, the distribution remains subject to ordinary income tax.

Required Minimum Distributions (RMDs) from Keogh plans typically begin when the account owner reaches age 73. These mandatory annual withdrawals must be taken to avoid a penalty. The penalty for failing to take an RMD, or taking less than the required amount, can be substantial, potentially reaching 25% of the amount that should have been withdrawn. If the account owner is still employed by the business sponsoring the plan, RMDs might be delayed until retirement, unless they are a 5% owner of the business.