A Keogh Plan is a retirement account for self-employed workers and business owners

• A Keogh plan is a type of retirement investment account for self-employed workers and business owners.
• Contributions to a Keogh plan are made pre-tax, while withdrawals in retirement face income tax.
• Certain types of Keogh plans may have higher contribution limits than other retirement accounts.

A Keogh plan is a type of retirement account that can be set up by self-employed workers. Referred to as "H.R. 10" or "qualified plans" by the IRS, Keogh plans were initially the only way for unincorporated businesses to sponsor retirement plans for their employees. Now, with other options like SEP IRAs and 401(k) plans cropping up, Keogh plans are falling out of fashion.

Still, Keogh plans aren't totally extinct and can offer business owners a smart way to save for retirement.

How do Keogh Plans work?

Like other retirement accounts, Keogh plans invest your monetary contributions in a variety of assets, such as stocks, bonds, and ETFs. You, and potentially your employer, may make pre-tax contributions to a Keogh plan up to the limits set by the IRS, detailed below.

When it's time to withdraw from your Keogh plan, you can choose to receive your money in installments or a lump sum. You may choose how often your installment payments are made and the amount in each. If you choose a lump sum, it is taxed once on the amount that you would have paid if you had collected in installments, reducing the total tax hit.

Self-employed owners of small businesses and limited liability companies may also open Keogh plans for themselves. These qualifying employers must set up Keogh plans for their employees who have worked at the company for at least 1,000 hours over three or more years.

Common-law employees, partners and independent contractors cannot set up Keogh plans.

Note: Keogh plans are becoming less common, but they're still available to self-employed workers and their employees.

Types of Keogh plans

There are two types of Keogh plans: qualified defined-contribution plans and qualified defined-benefit plans.

Qualified defined contribution plans are largely characterized and regulated by the amount contributed to the account. The contributions, along with the earnings and losses of the account, will determine the benefits that are paid out in retirement.

Defined contribution plans can be further split into profit-sharing plans, where an employer can contribute an amount based on business profit to an employee's account, and money purchase pension plans, where contributions are fixed and not based on profit.

Qualified defined benefit plans focus more on guaranteeing set benefits. In order to do so, these plans often involve calculations to determine the contributions and investments needed to meet the defined benefits.

Note: A 401(k) plan is a prime example of a defined contribution plan, and a pension is a known example of a defined benefit plan.

Contribution and withdrawal rules

Contributions to a Keogh plan are made before taxes, so you can deduct your contribution amount from your taxes for the year you made the contribution. You pay taxes on the plan's total balance once you retire.

The IRS limits how much you can contribute to a Keogh plan each year depending on the type of plan.

Withdrawals from a Keogh plan can be made penalty-free starting at age 59 ½. Withdrawals before this time are subject to a 10% penalty, in addition to regular income tax.

You're required to take distributions from the account before age 70 ½, otherwise, a 15% penalty tax will apply.

Pros and cons of Keogh plans

It's important to understand both the benefits and drawbacks of a Keogh plan before choosing it as your retirement savings vehicle.

Keogh plans offer versatility to self-employed workers saving for retirement. Keogh plans can be opened as either a defined contribution or defined benefit plan, providing options for plan sponsors to choose from based on their retirement goals.

Plus, Keogh plans have high IRS contribution limits, making them a more attractive option to aggressive savers.

However, since Keogh plans have been upstaged by newer retirement accounts, they may be harder to find. Keogh plans are also more complicated, involving more administrative hurdles and costs. This includes the likely need for professional management due to the calculations required to set up a defined benefit plan.

Keogh vs. 401(k)

A 401(k) plan is a newer alternative to a Keogh plan, and while they have similarities, it's their differences that has helped the 401(k) gain more popularity.

A 401(k) is an employee-sponsored qualified defined contribution plan. Typically, employees can open a 401(k) if their employer offers one. The employee makes contributions and sometimes, depending on their policies, the employer will contribute a percentage, too.

While Keogh plans are available to only self-employed workers and their employees, 401(k) plans are more widely accessible. Those who are self-employed can open a solo 401(k), also known as a one-participant 401(k) or individual 401(k), which are almost identical to traditional 401(k) plans.

One-participant 401(k) plans allow self-employed workers to contribute an additional 25% of net earnings to the account on top of the traditional contribution limits ($19,500 in 2021), totaling $58,000 for 2021.

401(k) plans are relatively easy to set up and manage, and do not come with the administrative burdens that Keogh plans do.

Note: Keogh plans aren't the only retirement savings option for the self-employed. 401(k) plans are just as, if not more, accessible these days, as are SIMPLE IRAs.

The financial takeaway

A Keogh plan can be a handy retirement savings vehicle for those who are self-employed. Keogh plans offer savers high contribution limits, pre-tax contributions, and the option to choose between defined benefit and defined contribution types.

However, Keogh plans are becoming less popular and less available, as lower maintenance 401(k) and IRA plans become more and more attractive savings options. Keogh plans may also come with more costs, like professional management, so it's important to weigh whether a Keogh plan is smartest for both your current financial situation and your retirement goals.