10 basics about Keogh and SEP-IRA retirement plans - simplified employee pension - Finance - column

Home Office Computing, Feb, 1991 by Linda Stern

There's still enough time to stash away some of your 1990 self-employment earnings in a tax-deferred retirement account, that great perquisite of the independent business person.

Gary Lesser, a New York City attorney who specializes in benefits consulting for small- to medium-size businesses, points out that Keogh and simplified employee pension (SEP) retirement accounts can provide great advantages for people who own corporations or partnerships, or are sole proprietors (even if only part-time), but that too many entrepreneurs are turned off by the legal jargon and administrative burdens and complexities that accompany those plans. There's no need to be. Let's cut through the jargon to get at what you need to know.

SEPs and Keoghs are the best financial perks available. It's very profitable to build your nest egg with pretax dollars. In the 28 percent bracket, you'll save $280 in federal taxes alone for every $1,000 you invest in a retirement plan. And as the money builds up tax-deferred, it really makes a difference: T. Rowe Price, a Baltimore mutual-fund company, estimates that if you save $2,000 a year in a tax-deferred account earning 8 percent, you'll have $12,671 in five years and $244,691 in 30 years. If you had been taxed on the interest at the 28 percent margin, you would have only $8,079 after five years and just $109,148 after 30 years.

Keoghs and SEPs are typically better than IRAs. After the Tax Reform Act of 1986, most Americans lost their eligibility for tax-defeffed individual retirement accounts. Even if you still qualify for a tax-deferred IRA (which means you are covered by no other pension plan, even through a spouse, and that you earn less than $25,000 as a single taxpayer or $40,000 as a couple), you can shelter more retirement savings in a Keogh or SEP, also called a SEP-IRA.

A SEP plan is simpler than a Keogh. A SEP works just like an individual retirement account, except that its eligibility requirements aren't restricted the way standard IRAs' are. There are no requirements that you continue contributing to a SEP or that you contribute at all during lean years. You can establish a SEP even if your spouse is covered by a pension plan. Even if you have your own pension plan from a regular job, you can set up a SEP for your self-employed earnings. You can't do that with a regular IRA. You can set up a SEP-IRA simply by going to a bank, mutual-fund company, or brokerage house and filling out one form.

Here's where the government requirements come in: Every year, you are allowed to deduct SEP-IRA deposits of up to 15 percent of your taxable business income after adding back in half of your self-employment tax, but after subtracting the SEP deposit. That means you have to know how much you're going to contribute before you can calculate your contribution. There's a basic calculation that will handle that for you, and it comes down to this: You can deduct contributions of up to 13.0434 percent of your taxable business income every year, after you add back in half of your self-employment tax. If the bottom line on your schedule C is $50,000, your self-employment tax is $7,650 in 1990. Add half of that back in, for a total of $53,825, and multiply it by 0.130434. The result, $7,020, is your allowable SEP-IRA contribution. Your yearly contribution cannot exceed $30,000.

Keoghs are more complicated than SEPs, but potentially more profitable. Keoghs are established under different IRS standards that require a higher level of setup documentation than for SEPs and thus are more complicated. Still, any good bank, brokerage, or mutual-fund company should be able to guide you through the forms if you decide to establish a Keogh. And last year the IRS eased the annual reporting requirement on Keoghs-now you have to report on your plan annually only if it has amassed more than $100,000.

One advantage of Keoghs over SEPs is an income-averaging provision for withdrawal of the funds at retirement. If you retire at 59 1/2 and withdraw a sum from your Keogh account, you don't have to pay tax on it all at once-you can average it as income over five years (or 10 years if you were 50 years old before January 1986), which reduces your tax liabilities. With a SEP, you would have to pay tax on the entire withdrawal in the year you took the money out. However, with either plan you can spread out the tax burden by making withdrawals gradually throughout your retirement.

There are two types of Keogh plans--one's more flexible, the other allows bigger deductions. When you open your Keogh account, you need to decide which type of plan you want: profit-sharing or money-purchase. Profit-sharing Keogh plans give you flexibility. You can contribute as much or as little as you want every year, as long as you stay below the maximums, which are the same as the SEP limits: 13.0434 percent of your taxable business income, after adding to your income half of your self-employment tax, with contributions not to exceed $30,000. With a profit-sharing Keogh, you don't have to put anything at all into the plan if you don't want to.