It pays to pay attention to letters from your banks and brokerages. If you don’t you could end up owing money to the government.
The Keogh Plan is a popular alternative to a traditional pension for individuals who are self-employed. It’s a tax-deferred retirement plan in which contributions are tax-deductible and mandatory distributions begin at age 70 years and 6 months. It was a popular option in the 1980s and 1990s, coinciding with a growth in 401(k) plans, although legislation established Keogh Plans in 1963.
In 2001, Congress enacted a law that changed laws pertaining to Keogh Plans. This change necessitated updates to account paperwork to be handled by participants, but many account holders were either uninformed or ignored notifications from their banks and brokerages.
If the Internal Revenue Service audits a retirement plan and discovers that its language is noncompliant under current law, any contributions made to the plan are not tax-deductible. All tax returns for the years affected must be redone, and earnings for the period of the audit, generally three years, are treated as taxable income. In addition, interest and often penalties, as well as taxes, are assessed.
The bottom line is that all contributions made to the Keogh would be considered non-deductible, and anyone found to be out of compliance would owe taxes and penalities.
Professionals interviewed in a New York Times article recommend rolling Keogh Plan funds over into a SEP IRA. SEP IRAs, thanks to the same law that complicated the Keogh, now offer benefits above and beyond the older type. That won’t get you out of trouble if your Keogh was non-compliant. There is still a cumbersome process to clear if you haven’t been following the new rules.
It means assembling the original plan documents and all the amendments that the bank or brokerage offered for its prototype documents; filling out forms in a 70-page document, Rev.Proc.2006-27; and paying a $750 fee to the I.R.S. for plans covering 20 people or fewer. Most people will need a pension consultant to do the paperwork, he said, and that could cost several thousand dollars.
This is another reason amongst many arguing for the simplification of tax code.
For Keogh Plans, a Technicality Could Crack a Nest Egg [New York Times]
Updated June 22, 2016 and originally published July 30, 2007.