Maximize Your Allowable Retirement Plan Contributions

Q: What business retirement plan do you recommend for people who are self-employed?

A: I recommend you take a look at a KEOGH retirement plan. This would give you the ability to make significant contributions to this plan--upwards of $165,000 each and every year (it rises to $170,000 for 2005).

A KEOGH retirement plan is set up by a self-employed person, and it provides tax-deductible contributions and tax-free income accumulation (growth) until withdrawn. You may set up your own KEOGH plan and contribute to it without advance approval. However, advance approval is advisable, and you may ask the IRS in a determination letter to review the plan.

There are two types of plans:

Defined-benefit plan: This kind of plan provides in advance for a specific retirement benefit, funded by quarterly contributions based on an IRS formula and actuarial assumptions.

• This may prove costly if you have older employees who must be provided with proportionate defined benefits.
• It requires that you contribute to your employees' accounts--even if you do not have profits.
• These plans are for individuals who are able and willing to put away more than $41,000 per year. The exact amount you can contribute will depend on the results of an actuarial analysis for each individual employee.

The maximum annual retirement benefit under a defined-benefit plan may not exceed 100 percent of the participant's average compensation for the three consecutive years of highest compensation as an active participant, or $165,000, whichever is less (it goes up to $170,000 for 2005). This limit may have to be reduced if benefits begin before the full Social Security age, currently age 65. For defined-benefit plans only, a minimum coverage rule requires that a plan must benefit at least the lesser of the following; either 50 employees or the greater of 40 percent of all employees or two employees.

Defined-contribution plan: This kind of plan does not fix a specific retirement benefit, but rather sets the amount of annual contributions so that the amount of retirement benefits depends on both contributions and income earned on these contributions.

Defined contribution plans can take either of the two following forms, or a combination of both:

• A profit-sharing plan: Contributions to the plan are contingent on your business having profit from which to pay the contributions. You can contribute up to 20 percent of your earnings from self-employment.
• A money-purchase plan: This kind of plan requires fixed contributions regardless of your business profits--even if you have a loss. You can contribute more to these plans than you can to either a "profit-sharing" plan or a SEP-IRA. As an owner, you can contribute 100 percent of your self-employment income or $41,000 ($42,000 for 2005) per year, whichever is less. Note: The maximum deduction percentage for regular employees under a KEOGH defined-contribution money-purchase plan is 25 percent of their wages.
• Paired plans: This kind of plan combines the profit-sharing plan and the money-purchase plan. You can attain the maximum contribution possible (100 percent) that you can get (as an owner) with the money-purchase pension plan, but have some of the flexibility that comes with a profit-sharing plan.

Both defined-benefit and defined-contribution plans may take into account Social Security benefits for employees. KEOGH plans allow for Social Security integration, effectively allowing those in the business who are high-income earners (usually the owners) to receive larger percentage contributions for their accounts than the less highly compensated employees. The logic behind this idea is that Social Security taxes top out after you earn more than $87,900; Social Security allows self-employed business owners (and key employees) who earn in excess of this amount to make up for this ceiling.

Note: The information in this column is provided by the author, not Entrepreneur.com. All answers are general in nature, not legal advice and not warranted or guaranteed. Readers are cautioned not to rely on this information. Because laws change over time and in different jurisdictions, it is imperative that you consult an attorney in your area regarding legal matters and an accountant regarding tax matters.

David Meier is the founder and COO of Business Development Coaching, a company that provides small-business owners with ongoing business coaching.