Key Points
Minimum Funding Standards
All Keogh plans must meet ERISA’s minimum funding standards, which require employers to actually contribute to the retirement plans they establish — not merely promise to do so. Special penalty excise taxes are imposed on employers who fail to meet these standards:
- A 10% initial excise tax is imposed on the funding deficiency. This tax is annual and cumulative — it continues each year the deficiency exists.
- A 100% additional tax may be imposed if the deficiency is not corrected within a specified period.
| Plan Type | Minimum Funding Standard |
|---|---|
| Money purchase (DC) pension plan | The amount required by the plan’s own contribution formula, established when the plan was adopted |
| Profit-sharing (DC) plan | Discretionary each year — employer determines the amount annually |
| Defined benefit plan | Actuarially determined amount to fund promised benefits, adjusted for unfunded liabilities and investment gains/losses |
As an alternative to the actuarial funding method for defined benefit plans, the employer may purchase a contract from an insurance company that provides the benefits promised under the plan. This is why defined benefit plans are sometimes called “annuity purchase plans.” To qualify as the funding vehicle, the insurance contract must:
- call for level, annual premiums payable each year the participant is covered, through no later than normal retirement age,
- provide benefits guaranteed by the insurance company equal to the amount promised by the plan at normal retirement age,
- be issued by an insurance company licensed to operate in the state where the plan is located, and
- be fully paid by the employer — the policy must not have lapsed, and no loans against the policy may be outstanding during the plan year.
In addition, the benefits must not be subject to a security interest, and no outstanding loans against the policy are permitted during any plan year.
Major Funding Methods
There are three principal methods for funding a Keogh plan. Since the owner-employee in many cases controls both the establishment and operation of the plan, the choice of funding method is particularly significant:
When a trust is used, a formal legal instrument transfers legal title to property to a trustee, who holds and invests the assets for the benefit of plan participants. All contributions are invested by the trustee in the trustee’s name, but exclusively for participants’ benefit.
A bank, trust company, or other financial institution may serve as trustee. Under TEFRA (effective 1983), an owner-employee may serve as trustee of his or her own Keogh plan — the prior requirement that the trustee be a bank or other approved institution was eliminated.
The Internal Revenue Code does not restrict the form of investments a trustee may choose. However, a Keogh plan that covers employees in addition to the self-employed person is subject to ERISA’s fiduciary standards:
- a duty to diversify investments in order to minimize the risk of large losses, unless it is clearly not prudent to do so, and
- the statutory prudent person rule governing the trustee’s general conduct.
An owner-employee may control the plan’s investment policy by specifying which investments are to be made, or by retaining veto power over the trustee’s investment decisions. In this case, the trustee is relieved of liability for losses in the owner-employee’s account that result from the owner’s exercise of investment control. However, the owner-employee who controls investment policy remains a fiduciary with respect to the accounts of other participants.
If the trust is funded solely through ordinary life insurance contracts, the death benefits provided must not exceed 100 times the monthly retirement income provided by the plan. Additionally, a sole proprietor may deduct trustee fees charged for maintaining the trust in addition to the maximum allowable Keogh contribution.
A Keogh plan may also be funded through direct purchase of annuity contracts from an insurance company, without the use of a trust (though annuity contracts may also be purchased through a trust). This approach removes the need for a formal trust document.
The 1962 Self-Employed Individuals Tax Retirement Act redefined “annuity” to mean a nontransferable annuity contract. A contract is nontransferable if the owner cannot sell, assign, discount, or pledge the contract as collateral for a loan or security for any obligation, to any person other than the insurance company that issued it. The owner retains the right to name a beneficiary and elect a joint and survivor option.
This nontransferability requirement eliminated the concern that participants could misuse individual policies and removed the need for a trust when plans are funded through individual annuity contracts.
A trusteed pension plan purchases individual level-premium annuity contracts from an insurance company for each covered employee. The trustee holds legal title to all contracts prior to their distribution to qualifying annuitants. Although the individual contracts contain no express transferability restriction, while held by the trustee they satisfy the nontransferability requirement — because the trustee, not the individual participant, holds and controls the contracts.
An employees’ non-trusteed annuity plan uses individual contracts that state on their face: “This contract may not be sold, assigned, discounted, or pledged as collateral for a loan or as security for the performance of an obligation or for any other purpose, to any person other than this company.” These contracts satisfy the nontransferability requirement without the need for a trust.
The 1962 Act also expanded the definition of “annuity” to include nontransferable face-amount certificates issued by investment companies under the Investment Company Act of 1940. These are securities that obligate the issuer to pay a stated sum at a fixed future date in exchange for periodic installment payments (installment type) or a single lump sum (“fully paid” type). They function similarly to conventional annuities and may be used as an alternative Keogh funding vehicle.
Instead of a trust or direct annuity purchase, a Keogh plan may be funded by depositing contributions into a custodial account — a less formal arrangement than a trust, established with a third-party custodian. This provision was added by the 1962 Self-Employed Act.
Originally, custodial account funds had to be invested entirely in:
- annuity, endowment, or life insurance contracts issued by an insurance company, or
- shares in a mutual fund.
Following ERISA’s enactment in 1974, these investment restrictions were removed. Custodial account investments are now governed by the same rules that apply to trusteed plans — including, for plans covering employees, ERISA’s fiduciary and diversification standards.