KEOGHS: RETIREMENT PLANS FOR SELF- EMPLOYMENT INCOME

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1 PensionPrimer KEOGHS: RETIREMENT PLANS FOR SELF- EMPLOYMENT INCOME A Topic of Interest to Retirement Plan Administrators Keoghs, tax-deferred retirement plans for self-employed individuals and their employees, generally work like any other qualified retirement plan, and offer the same tax advantages as other retirement plans. Selfemployed individuals may be able to contribute as much as $41,000 to a Keogh in The most important decision to make in setting up a Keogh is choosing which type of plan: a profit sharing plan, with a variable contribution rate and the availability of in-service withdrawals; or a money purchase plan, with a fixed annual contribution rate. This Pension Primer explores the issues and decisions surrounding the adoption of a Keogh, including the relative advantages and disadvantages of money purchase and profit sharing plans; contribution limits; plan features such as delayed vesting and in-service withdrawals; and minimum distribution requirements. A Keogh can be set up as either a defined benefit plan or a defined contribution plan. In this Primer we discuss defined contribution Keogh plans only.

2 GENERAL DESCRIPTION A STANDARDIZED PROTOTYPE PLAN LIKE THE ONE TIAA-CREF OFFERS, ELIMINATES THE NEED FOR MOST SELF- EMPLOYED INDIVIDUALS TO SUBMIT THE PLAN DOCUMENT TO THE INTERNAL REVENUE SERVICE (WHICH ENTAILS FEES) TO ENSURE THAT THE PLAN IS QUALIFIED. A Keogh plan is a qualified tax-deferred retirement plan for selfemployed individuals (sole proprietors or partnerships) and their employees. Keogh plans are named after Congressman Eugene Keogh, who sponsored the original legislation in the 1960s to create plans for self-employed persons that would allow them to benefit from many of the same tax advantages previously offered only under corporate retirement plans. Two major tax-savings benefits that Keogh plans offer are tax-deductible contributions and tax-deferred growth. Keoghs, like all qualified plans, are subject to contribution limits and deduction limits under the Internal Revenue Code. The deduction limits may be significantly lower than the contribution limits, effectively limiting contributions to the maximum tax-deductible amounts since employers and self-employed individuals will generally not make plan contributions in excess of the amount that they can deduct from their taxable income. In addition, there may be excise taxes imposed on contributions in excess of the deductible amount. A defined contribution Keogh plan can be either a money purchase plan or a profit sharing plan. The passage of the Economic Growth and Tax Reconciliation Act of 2001 (EGTRRA) has made the profit sharing plan very desirable. Money Purchase Keogh A money purchase plan has a fixed contribution rate. The employer must contribute to the plan at the same rate each year. Once the contribution percentage has been set, it can be changed only if the employer amends the plan. Profit Sharing Keogh Under a profit sharing plan, contributions are made on a discretionary basis and allocated to the individuals accounts based on a fixed allocation formula (for example, in proportion to each participant s share of the sum of covered compensation of all participants). The 2 PensionPrimer TIAA-CREF Individual and Institutional Services, Inc. distributes securities products. For more complete information, call , for the prospectuses or read or download them at the TIAA-CREF Web Center: Read them carefully before you invest. TIAA (Teachers Insurance and Annuity Association) New York, NY issues annuities.

3 contribution amount can vary each year. There must be some expectation, however, that contributions will be regular and ongoing. Profit sharing plans may also permit in-service withdrawals. CONTRIBUTION LIMITS Many people with self-employment income also hold salaried positions and participate in employer-sponsored retirement and/or supplemental retirement plans, including 403(b) plans for nonprofit organizations or qualified plans such as 401(a) or 401(k) plans. Retirement plan contributions, including Keogh contributions, are subject to specific limits according to Section 415 of the Internal Revenue Code. Plus, under Section 401(a)(17) the maximum amount of compensation that may be taken into account in calculating the contribution amount is $205,000 in As a result, Keogh contributions may be limited and may also have to be aggregated with other (non-keogh) retirement plan contributions made by the Keogh plan owner and his or her employer. Following are general guidelines to help determine which limit applies to the Keogh plan owner. Please note that plan aggregation to determine contribution limits applies only to the plan owner, and not to any employees covered under the plan. For Persons Who Participate in a Keogh Only Someone who is self-employed, for whom the Keogh is currently the only retirement plan, will be able to contribute up to the maximum amount within Internal Revenue Code limits. The maximum contribution amount for the Keogh in 2004 is the lesser of $41,000 or 100% of compensation from self-employment income. Self-employed individuals can also make contributions for employees covered under the plan. The maximum contribution amount is the lesser of $41,000 or 100% of the employee s compensation. However, an owner employee s deduction for contributions to his or her own account in 2004 is limited to the lesser of 20% of net earnings from self-employment or $41,000. There may be excise taxes imposed on the nondeductible contribution. Therefore, it s recommended that contributions not exceed the deductible amount. Examples of Self- Employment Income Virtually any type of self-employment income can be used as a basis for making contributions to a Keogh plan. Persons who serve on a Board of Directors or as a trustee, receive book royalties, perform consulting services, do lecture tours, or own an unincorporated business may all be able to direct this income to a Keogh to increase their retirement savings. Following are some specific examples of income that may or may not qualify as self-employment income. A salaried doctor is not considered self-employed, even if a corporation solely owned by the doctor pays the salary. Consultants who receive fees for their services are considered self-employed. A salaried employee (with no ownership in the partnership) of a law firm is not a self-employed person. He or she is an employee of the firm. PensionPrimer 3

4 Who can open a Keogh with TIAA-CREF? In addition to having self-employment income, a person must meet one of the following criteria in order to be eligible to open a Keogh with TIAA-CREF. The person must: be employed by, or be a trustee (director) of, an eligible institution; or have an existing contract with TIAA or CREF (other than a group insurance product; also, TIAA-CREF Mutual Funds or TIAA-CREF Life Insurance Company products are not applicable for this purpose); or be the spouse or surviving spouse of a person who meets one of the above criteria. When we refer to an eligible institution, we mean types of institutions eligible to participate in the TIAA- CREF system. This may include colleges, universities, private schools, public K-12 schools, teaching hospitals, museums, cultural institutions, and libraries, as well as other nonprofit organizations or governmental entities. continued on next page For Persons Who Participate in a 403(b) Plan and a Keogh All contributions made to a Keogh plan must be aggregated with the contributions to a 403(b) plan for a self-employed individual who owns more than 50% of the employer sponsoring the Keogh plan. The maximum contribution to all plans is the lesser of $41,000 or 100% of compensation in For Persons Who Participate in a Qualified Plan and a Keogh The contribution limits for the qualified plan (such as a 401(a) or 401(k) plan) of a nonprofit employer or government and the Keogh are generally calculated separately. The maximum contribution to each plan can be as much as $41,000 (or 100% of compensation, if less), potentially resulting in a maximum combined amount of $82,000 in For Persons Who Participate in a Qualified Plan, a 403(b) Plan, and a Keogh Contributions to the qualified plan are calculated separately, while contributions to the 403(b) plan and the Keogh for the self-employed individual (but not the employees) must generally be aggregated to calculate the Section 415 limit. The maximum contribution to the qualified plan for an individual can be $41,000 in 2004 while the maximum contribution to the 403(b) plan and the Keogh together would also be $41,000 (or 100% of compensation, if less). Thus the potential maximum combined contribution to all plans for the selfemployed individual (but not the employees) is $82,000 in DEDUCTION LIMITS The maximum amount that can be deducted by the self-employed is based on earnings from self-employment. For Self-Employed Individuals 4 PensionPrimer The maximum amount that can be deducted for contributions to an owner employee s account is 20% of adjusted compensation from self-employment income (compensation from self-employment income reduced by one-half of the self-employment

5 tax). For example: Assume compensation from self-employment income is $100,000 and the self-employment tax is $13,206. Therefore, the maximum tax-deductible contribution would be $18,679 [20% of ($100,000 $6,603)]. Contributions exceeding the deduction limit are excess contributions so they do not reduce taxable self-employment income and may be subject to a 10% excise tax. Therefore, the maximum contribution is effectively the maximum tax-deductible contribution. For Employees Covered Under the Plan The maximum amount of contributions for non-owner employees that can be deducted is 25% of all covered employees compensation. continued from previous page Partnerships In the case of partnerships, at least 50% of the partners must be eligible according to the above criteria. Also, the partnership must be primarily engaged in education or research. Individuals in partnerships who are interested in opening a Keogh with TIAA-CREF should request an Eligibility Questionnaire for the partnership by calling PLAN FEATURES When an individual completes the Adoption Agreement(s) to set up a Keogh, he or she will be asked to choose from among various options for plan features. These include plan options under eligibility to participate, the vesting schedule for all persons covered under the plan, and (for the profit sharing plan only) in-service distributions and hardship withdrawals. In addition, Keoghs are subject to many of the same rules as other qualified plans, including minimum distribution requirements. These features are discussed in more detail below. Plan Owners Are Also Their Own Employees Owners should keep in mind that they are treated as their own employee under the plan they choose to create. For example, the schedule for plan participation and the vesting schedule for a Keogh plan apply equally to the owner as well as to any covered employees. Eligibility to Participate A plan can impose minimum age and/or service requirements for purposes of eligibility to participate. This means that in setting up the plan, the Keogh plan owner can choose to make participation available immediately, or instead choose to include a waiting period or attainment of a stated minimum age of no older than age 21 as a requirement for participation. PensionPrimer 5

6 Vesting A Keogh plan owner can choose to have any of the following vesting rules in place: KEOGHS ARE SUBJECT Cliff vesting: 100% vesting after no more than five years of service. A participant who terminates prior to completing this period of service will forfeit all accrued benefits. Graded vesting: The participant benefits vest at a rate of 20% a year beginning with the third year of service. For example, after three years the person is 20% vested, after five years, 60%, and after seven years, 100%. Immediate vesting: The person is 100% vested when participation begins. TO MANY OF THE SAME RULES AS OTHER QUALIFIED PLANS, INCLUDING MINIMUM DISTRIBUTION REQUIREMENTS AND INCOME AVERAGING. When an employee terminates with less than full vesting, the plan owner can apply the nonvested monies (forfeitures) in one of two ways: either use the monies to reduce future employer contributions, or allocate them among the remaining employees. If the plan is terminated for any reason, the participating employees become 100% vested. Distributions In-Service Cash Withdrawals In-service cash withdrawals can be made available for profit sharing plan participants after a given number of years of participation in the plan and/or age In-service cash withdrawals are not permitted from a money purchase plan. For money purchase plans, distributions are available only if a person retires, terminates employment, becomes disabled, or dies. Early Distributions An individual who takes a distribution from the Keogh plan before age is subject to all taxes due and may also be subject to a 10% early distribution tax. The 10% early distribution tax does not apply to certain distributions, including those: made to a beneficiary, or the employee s estate on or after the death of an employee; due to the participant having a qualifying disability; made as part of a series of equal periodic payments for the life or life 6 PensionPrimer

7 expectancy of the employee or the joint lives or joint life expectancies of the employee and his or her designated beneficiary; distributions beginning after the employee separates from the service of the employer in the calendar year he or she attains age 55; made according to a Qualified Domestic Relations Order (QDRO); or made to an employee to cover medical expenses greater than 7.5% of the person s Adjusted Gross Income. Deadlines for Opening and Contributing to a Keogh Plan A Keogh plan must be in existence (e.g., properly adopted and with at least an initial contribution having been made) by the end of the tax year Taxation of Distributions Federal law requires 20% tax withholding on all distributions eligible for rollover (i.e., lump-sum distributions, partial withdrawals), if distributed to the participant, or, if applicable, the beneficiary instead of being directly rolled over to another plan or IRA. State and local taxes may apply. Individuals cannot waive this withholding requirement. Mandatory withholding does not apply to required minimum distributions or annuity payments because they are not eligible for rollover. Hardship Withdrawals Profit sharing plans can allow participants to withdraw all or part of their vested account accumulations in the event of a hardship, defined as an immediate and heavy financial need. This can include expenses for certain types of medical care, the purchase of a principal residence, postsecondary educational expenses for the participant as well as his or her family and dependents, and payments to prevent eviction from a principal residence. Money purchase plans cannot provide for hardship withdrawals. Minimum Distribution Requirements Keogh participants the plan owner and any employees participating in the plan generally must begin to take distributions by April 1 of the year following the year in which the person turns However, an employee who is not an owner of more than 5% of the plan sponser and who has not yet retired by can postpone minimum distributions until April 1 of the calendar year following the calendar year in which the person retires. in order to make contributions that will count for that tax year. Once the Keogh has been properly opened in a timely manner, Keogh plan owners can make contributions that will count for that tax year during that year or in the following year until their tax filing deadline (usually April 15 of the following year), including extensions. For example, provided the Keogh plan owner has properly adopted a Keogh and made an initial contribution by December 31, 2003, he or she will have until April 15, 2004 to make additional contributions to the plan for See page 9 for information on how rollovers and transfers affect making contributions between January 1 and April 15. Income Averaging Ordinarily, retirement income is taxable in the year the person receives it PensionPrimer 7

8 whether the person receives a lifetime annuity, payments for a fixed period, or a lump-sum cash withdrawal. Under certain circumstances, however, a person who receives a lumpsum distribution from a qualified plan such as a Keogh plan may be permitted to compute the tax as if the distribution were received over several years. In this way the individual can reduce the amount of tax owed. IN-SERVICE CASH WITHDRAWALS CAN BE MADE AVAILABLE FOR The Small Business Job Protection Act of 1996 eliminated five-year income averaging for lump-sum distributions made after December 31, Ten-year averaging remains available for those who attained age 50 before January 1, 1986, provided the individual was a plan participant for at least five years. It can be elected only once, and the 1986 income tax rates must be used. This may not always be an advantage. Loans Keogh plans can permit loans. (TIAA-CREF does not permit loans from the Keogh.) PROFIT SHARING PLAN PARTICIPANTS AFTER A GIVEN NUMBER OF YEARS OF PARTICIPATION IN THE PLAN. ROLLING OVER OR TRANSFERRING FUNDS TO A KEOGH PLAN Deciding to Roll Over or Transfer Generally an individual can roll over or transfer funds to a Keogh from another Keogh or from another qualified plan, a 403(b) plan or governmental 457(b) plan. Money that is presently in a Keogh can be rolled over or transferred to IRAs, other qualified plans, including other Keogh plans, or 403(b) plans. Outlined below are various factors for individuals to consider in deciding whether to roll over or transfer funds. Should Funds Be Moved to Another Keogh or to an IRA? 8 PensionPrimer In general, if a self-employed individual has a Keogh and is actively contributing to it, and wishes to move the funds to another financial services company, he or she should consider moving the funds into a new Keogh at that company. If the existing Keogh is inactive, the individual should consider moving the money into an IRA. By inactive we mean a Keogh to which the individual does not plan to contribute in the future and may not have contributed for a number of years. In

9 that case, he or she may no longer need to maintain a Keogh for those funds, and an IRA might be less burdensome administratively. How a Rollover Differs From a Transfer If the money in the current Keogh is eligible for distribution, the individual can do a rollover. If not, he or she can do a transfer, which moves the money directly from the current financial services company to another company. Whether a rollover or a transfer would be appropriate will obviously depend upon a variety of factors, including the terms of the existing plan and the individual s particular circumstances. A rollover requires an event that qualifies the participant to receive a distribution. What constitutes a distribution will vary according to the terms of the plan. Individuals should be sure to consult their tax advisors before taking a distribution, to avoid additional penalty taxes. RELATED TO ELIGIBILITY TO PARTICIPATE IS THE For a profit sharing plan, depending upon the terms of the plan, a person may be eligible to receive benefits: upon or after attaining age ; termination of employment or retirement; or when eligible for in-service withdrawals under the terms of the plan, even if termination of employment has not occurred, for example, because of disability or hardship. For a money purchase plan, under the law, the plan can permit distributions only when one of the following events occurs: separation from service, retirement, death or disability, or plan termination. A plan termination must satisfy the requirements set forth under the law. CHOICE OF A VESTING SCHEDULE. HOW SOON EMPLOYEES BECOME VESTED WILL HAVE AN IMPORTANT EFFECT ON There are generally two types of rollovers: a direct rollover and a 60-day rollover. A direct rollover is done trustee to trustee and there is no mandatory tax withholding. A 60-day rollover occurs when a person receives a distribution of funds from the current plan, and within 60 days puts the money into a new plan. Mandatory 20% federal income tax withholding applies to the latter type of transaction. (State and local taxes may also apply.) In this case, the participant would only have 80% of the distribution amount to roll over and would be subject to taxation on the 20% withheld unless the participant were able to roll over the full distribution amount. If the participant makes up the amount withheld out of his or her own funds and transfers the full amount of the distribution as a rollover contribution, the amount withheld would not constitute taxable PLAN COSTS. PensionPrimer 9

10 Prior Plan Provisions The Keogh plan owner is agreeing to adopt a new prototype plan and its provisions when opening a Keogh with a new carrier and transferring or rolling over funds from another company. Because the new prototype plan document was not designed to reflect the provisions of the prior plan, we recommend seeking legal counsel before terminating a Keogh, with particular attention to anticutback rules when the Keogh plan covers employees. These rules currently prevent the implementation of a plan amendment that reduces or eliminates a participant s accrued benefits (e.g., an optional form of benefit or an early retirement benefit). If an existing plan s terms differ from those of any new plan, the terms of a new plan may not comply with the anticutback rules. income and the amount withheld would be credited against the participant s federal income tax liability for that year. A transfer is generally accomplished as a direct movement of funds from one trustee to another (e.g., from another company to TIAA- CREF). Since no distribution of funds occurs, the funds movement is not recognized as income, and taxation is deferred. Transferring funds generally involves a continuation of a prior plan, whereas rolling over funds generally involves adopting a new plan. With a trustee-to-trustee transfer from one company to another between January 1 and April 15 of a given year for a Keogh plan in existence as of the end of the prior tax year, the plan owner may be able to contribute funds for the prior year to the new Keogh until April 15. Alternatively, the individual may choose to contribute to the prior plan before April 15 and then do the transfer, and have that contribution count for the prior tax year, and may also be able to contribute to the new Keogh for the current year. By contrast, when someone does a rollover between January 1 and April 15 of a given year for a Keogh plan in existence as of the end of the prior tax year, he or she generally cannot contribute additional funds after the rollover to the new Keogh and have those funds count for the prior tax year. If the person wishes to make a contribution for the prior tax year, he or she would have to first make the contribution before April 15 to the existing Keogh and then do the rollover. Contributions to the new Keogh could then be made for the current year. KEOGH PLAN ADMINISTRATION A number of administrative procedures are necessary to ensure that the Keogh is operated according to the plan document and other legal requirements. This is true for both types of Keogh plans: money purchase and profit sharing. Summary Plan Description 10 PensionPrimer When adopting or amending a plan when there are employees other than the spouse of the owner, the plan owner must provide each participant with a Summary Plan Description (SPD), generally in the case of a new plan within 120 days. Going forward, newly enrolled participants in the plan must receive the SPD within 90 days of becoming participants. Plan amendments frequently need to be

11 followed by a summary of material modifications within 210 days after the end of the plan year in which the change was adopted. Form 5500 Filing Each year the Keogh plan owner may have to file Form 5500 (Annual Return/Report of Employee Benefit Plans), similar but not identical to those filed for other qualified plans. The forms are due by the last day of the seventh month after the close of the plan year. For example, if the employer has a calendar year plan (ending December 31), the Annual Return/Report should be filed by the following July 31. The appropriate form depends on the size of the plan. A one-participant plan is a plan that covers only a sole proprietor or the sole proprietor and spouse, or only one or more partners and their spouses. The IRS does not require Form 5500 for a one-participant plan with $100,000 or less in total plan assets at the end of every year, or for two or more one-participant plans owned by the same individual that together have $100,000 or less in total assets at the end of every plan year. The plan owner may file Form 5500EZ if all of the following conditions are met: The plan has less than $100,000 in total plan assets at the end of the plan year, or two or more plans have a total of less than $100,000 at the end of the plan year; TRANSFERRING FUNDS GENERALLY INVOLVES A CONTINUATION OF A PRIOR PLAN, WHEREAS ROLLING OVER FUNDS The plan is a one-participant pension benefit plan as of the first day of the plan year; The plan meets the minimum coverage requirements of Section 410(b) of the Code without being combined with any other plan; The plan does not provide any benefits for anyone other than those individuals who fit within the one-participant plan definition and their spouses; The plan does not cover a business that is a member of an affiliated service group, a member of a controlled group, or a member of a group of businesses under common control; and The plan does not cover a business that leases employees. GENERALLY INVOLVES ADOPTING A NEW PLAN. The plan owner must file Form 5500 if the plan is not otherwise exempt and has fewer than 100 participants at the start of the plan PensionPrimer 11

12 year. Schedule I is now used in place of Forms 5500-C and 5500-R to provide financial information for small plans. Schedule SSA is used to report certain separated participants and is attached to Form Summary Annual Report (SAR) Keogh plans that cover nonspousal employees must distribute a summary of the Annual Return/Report each year to plan participants and their beneficiaries. The Summary Annual Report (SAR) provides information about the plan s annual financial status. The plan owner must distribute the SAR by the last day of the ninth month following the close of the plan year. For example, a plan that has a year ending December 31 must distribute the SAR by the following September 30. This does not apply to a one-person plan. Calculating Annual Contributions Each year Keogh plan owners must calculate annual contributions for themselves and for their employees. Employee Eligibility Requirements Owners of Keogh plans covering employees under the Keogh must monitor eligibility requirements for plan participation and provide enrollment materials in a timely manner. Although this Pension Primer is designed to give you general guidance on which type of plan is more likely to fit the needs of an individual, we strongly recommend that the individual opening a Keogh plan consult with legal counsel or a financial advisor before establishing the plan. OPENING A KEOGH WITH TIAA-CREF For more information about adopting a Keogh with TIAA-CREF, individuals can call one of our Keogh specialists at They can calculate how much an individual may be able to contribute to a Keogh. The TIAA-CREF Web Center at has detailed information about opening a Keogh with TIAA-CREF. When you set up a Keogh plan with TIAA-CREF, we will help with all the administrative requirements. A10415 Printed on recycled paper. C / Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), New York, NY 10017