SEP vs. Keogh Plans: Which is Right for You?

If you own a small business, then you have several options to choose from when it comes to retirement planning. If you want to be able to put away more than the individual retirement account (IRA) contribution limit each year, then you need to think about creating a retirement plan for your business, one that will help you to defer taxation and add to your company’s bottom line. The type of plan that is right for you will depend in large part on your own circumstances and needs. Many business owners choose to open a simplified employee pension (SEP) plan while others favor Keogh arrangements. But which type is best for you?

Both Keogh and SEP plans allow business owners and employees to make elective pretax deferrals from their wages into the plan, where the money will grow tax-deferred until retirement. Owners and participants can deduct the amounts that they contribute from their income each year, and all distributions that are taken from them during retirement are taxed as ordinary income. Both types of plans are designed primarily for self-employed taxpayers who own their own businesses, but employees can also participate in these plans. Both types of plans can be opened at just about any type of financial institution, such as a bank, brokerage or investment firm, life insurance carrier or mutual fund company. Both types of plans can invest in a wide range of financial instruments, including stocks, bonds, certificates of deposit (CDs), mutual funds, exchange-traded funds (ETFs), annuities and other equity and fixed-income instruments. (For more, see: Plans the Small-Business Owner Can Establish.)

However, those who wish to invest directly in real estate will not be able to do so inside either type of plan. The maximum amount that can be contributed to either type of plan in 2015 is the lesser of $53,000 or 100% of the owner or employee’s compensation. The maximum amount that can be deducted by the employer is equal to 25% of the employees’ total combined compensation. Although these limits do apply to Keogh plans, the actual amount that can be contributed and deducted is based on a more complex calculation that takes the amount of the contribution itself into account.

Although SEPs and Keogh plans are alike in many ways, they are also fundamentally different types of plans. SEPs are fairly simple in structure and function solely as defined-contribution plans. They are not qualified plans and can be established with the submission of Form 5305-SEP to the Internal Revenue Service (IRS). In most cases, the business owner can get through the initial paperwork without the need for professional assistance. They resemble their individual retirement cousins in that they allow for prior-year contributions up to the filing deadline, even if they file for an extension. They have no annual reporting requirements and participants cannot borrow from their plan balances.

Employers are also not required to make a contribution in a given year to these plans, although they are required to make equal contributions for all full-time employees who are at least 21 years of age or have worked for the company part or full time for at least 3 of the past 5 years. (For more, see: SEP-IRAs: Contributions.)

Keogh plans are qualified plans that are much more complex in nature. They fall under Employee Retirement Income Security Act (ERISA) guidelines and require a complete plan document to be submitted in order to be established. In most cases, it’s probably wise to enlist a certified public account (CPA) or financial advisor to help you set one of these up. Keogh plans can have some tricky details that may come back to bite you if they are ignored. They can be structured as either defined-contribution or defined-benefit plans, and are usually more popular with very highly compensated individuals such as medical professionals or owners of unincorporated small businesses.

If they are structured as defined-contribution plans, their contribution limits are similar to those of other types of qualified plans, but defined-benefit Keoghs permit a maximum contribution of $210,000 for 2015 and 2016. If they are structured as defined contribution plans then they can be sub-structured to be either money purchase or profit-sharing plans. Many business owners opt for the latter form because it allows them to make variable contribution on an annual basis that correspond to their profit for the year. If profits are down next year, then their contribution can be less. Money purchase pension plans do not have this flexibility. The business owner must elect to contribute a definite percentage every year for the life of the plan. Penalties are assessed for any annual contributions that fall below that amount. They also come with annual reporting requirements on Form 5500, and loans are available in these plans within ERISA guidelines. (For more, see: An Introduction to the Keogh Retirement Plan.)

As stated previously, the answer to which of these plans is better will depend upon what you want from your plan. If you make several hundred thousand dollars a year, then you can make considerably larger deductible contributions to a defined-benefit Keogh plan each year. If your business has eligible employees for whom you would like to make retirement plan contributions, then a SEP makes more sense. Just remember that you will have to make the same contribution for each and every employee that you put in your own account each year. This is why most SEP plans are used by companies with a relatively small number of eligible employees. (For more, see: Business Owners: Rules for Qualified Retirement Plans.)

Choosing a retirement plan is an important decision that can have a substantial impact on both you and your employees. The right choice for you will depend upon your cash flow, balance sheet, investment objectives, risk tolerance and time horizon, as well as the nature and future prospects of your business. If you decide after reading this that neither of these plans exactly fits your needs, you may want to consider a solo, traditional or Roth 401(k) plan or a 412(i) plan if you are seeking a defined benefit. For more information on retirement plans and accounts, download IRS publications 590 and 575 from the IRS website at www.irs.gov or consult your tax or financial advisor. (For more, see: Retirement Plan Options for Small-Business Owners.)