A qualified retirement plan is a written plan you can set up for the exclusive benefit of your employees and their beneficiaries. It is sometimes called a Keogh or H.R. 10 plan.

You, or you and your employees, can make contributions to the plan. If your plan meets the qualification requirements, you can generally deduct your contributions to the plan. For more information, see Publication 560.

Your employees generally are not taxed on your contributions or increases in the plan's assets until they are distributed. However, certain loans made from qualified plans are treated as taxable distributions. For more information, see Publication 575.

Qualification requirements. To be a qualified plan, the plan must meet many requirements. They include requirements that determine the following.

• Who must be covered by the plan.
• How contributions to the plan are to be invested.
• How contributions to the plan and benefits under the plan are to be determined.
• How much of an employee's interest in the plan must be guaranteed (vested).

For more information, see Publication 560.

More than one job. If you are self-employed and also work for someone else, you can participate in retirement plans for both jobs. Generally, your participation in a retirement plan for one job does not affect your participation in a plan for the other job. However, if you have an IRA, you may not be allowed to deduct part or all of your IRA contributions. See Publication 590.

Kinds of Qualified Plans

There are two basic kinds of qualified retirement plans: defined contribution plans and defined benefit plans.

Defined Contribution Plan

This plan provides for a separate account for each person covered by the plan. Benefits are based only on amounts contributed to or allocated to each account.

There are two types of defined contribution plans: profit-sharing and money purchase pension.

Profit-sharing plan. This plan lets your employees or their beneficiaries share in the profits of your business. The plan must have a definite formula for allocating the contribution among the participating employees and for distributing the accumulated funds in the plan.

Money purchase pension plan. Under this plan, contributions are fixed and are not based on your business profits. For example, if the plan requires contributions be 10% of each participating employee's compensation, regardless of whether you have a profit, the plan is a money purchase plan.

Defined Benefit Plan

This is any plan that is not a defined contribution plan. In general, contributions to a qualified defined benefit plan are based on what is needed to provide definitely determinable benefits to plan participants. Your contributions to the plan are based on actuarial assumptions. Generally, you will need continuing professional help to administer a defined benefit plan.

Setting Up a Plan

The plan can be an IRS-approved master or prototype plan offered by a sponsoring organization. Or it can be an individually designed plan.

Master or prototype plan. The following sponsoring organizations generally can provide IRS-approved master or prototype plans.

• Trade or professional organizations.
• Banks (including savings and loan associations and federally insured credit unions).
• Insurance companies.
• Mutual funds.

Adoption of a master or prototype plan does not mean your plan is automatically qualified. It must still meet all the qualification requirements stated in the law.

Individually designed plan. If you prefer, you can set up an individually designed plan to meet specific needs. Although advance IRS approval is not required, you can apply for approval by requesting a determination letter. You may need professional help with this. The following revenue procedure and announcement will help you decide whether to apply for approval.

• Revenue Procedure 2001-6 in Internal Revenue Bulletin 2001-1
• Announcement 2001-77 in Internal Revenue Bulletin 2001-30.

Deduction Limit

The deduction limit for contributions to a qualified plan depends on the kind of plan you have.

In figuring the deduction for contributions to these plans, you cannot take into account any contributions or benefits that are more than the limits discussed under Limits on Contributions and Benefits in Publication 560.

Defined contribution plans. The deduction limit for a defined contribution plan depends on whether it is a profit-sharing plan or a money purchase pension plan.

Profit-sharing plan. Your deduction for contributions to a profit-sharing plan cannot be more than 15% of the compensation paid (or accrued) during the year to the eligible employees participating in the plan. You must reduce this limit in figuring the deduction for contributions you make for your own account. See Deduction of contributions for yourself, later.

Money purchase pension plan. Your deduction for contributions to a money purchase pension plan is generally limited to 25% of the compensation paid during the year to an eligible employee. You must reduce this limit in figuring the deduction for contributions you make for yourself, as discussed later.

Defined benefit plans. An actuary must figure the deduction for contributions to a defined benefit plan since it is based on actuarial assumptions and computations.

Deduction of contributions for yourself. To take a deduction for contributions you make to a plan for yourself, you must have net earnings from the trade or business for which the plan was set up.

Limit on deduction. If the qualified plan is a profit-sharing plan, your deduction for yourself is limited to the lesser of $35,000 or 13.0435% (15% reduced as discussed later under Net earnings reduced by adjusting contribution rate) of your net earnings from the trade or business that has the plan. If the plan is a money purchase pension plan, the deduction is limited to the lesser of $35,000 or 20% (25% reduced as discussed later under Net earnings reduced by adjusting contribution rate) of your net earnings.

Net earnings. Your net earnings must be from self-employment in a trade or business in which your personal services are a material income-producing factor. Your net earnings do not include items excluded from income (or deductions related to that income), other than foreign earned income and foreign housing cost amounts.

Your net earnings are your business gross income minus the allowable deductions from that business. Allowable business deductions include contributions to SEP and qualified plans for common-law employees and the deduction for one-half your self-employment tax.

Net earnings include a partner's distributive share of partnership income or loss (other than separately stated items such as capital gains and losses) and any guaranteed payments. If you are a limited partner, net earnings include only guaranteed payments for services rendered to or for the partnership. For more information, see Partnership Income or Loss under Figuring Earnings Subject to Self-Employment Tax in Publication 533.

Net earnings do not include income passed through to shareholders of S corporations.

Adjustments. You must reduce your net earnings by the deduction for one-half your self-employment tax. Also, net earnings must be reduced by the deduction for contributions you make for yourself. This reduction is made indirectly, as explained next.

Net earnings reduced by adjusting contribution rate. You must reduce net earnings by your deduction for contributions for yourself. The deduction and the net earnings depend on each other. You make the adjustment indirectly by reducing the contribution rate called for in the plan and using the reduced rate to figure your maximum deduction for contributions for yourself.

Annual compensation limit. You generally cannot take into account more than $170,000 of your compensation in figuring your contribution to a defined contribution plan.

Figuring Your Deduction

Use the following worksheet to find the reduced contribution rate for yourself. Make no reduction to the contribution rate for any common-law employees.

Rate Worksheet for Self-Employed

1)	Plan contribution rate as a decimal (for example, 10 1/2% = .105)
2)	Rate in line 1 plus 1 (for example, .105 + 1 = 1.105)
3)	Self-employed rate as a decimal rounded to at least 3 decimal places (line 1 × line 2)

Now that you have figured your self-employed rate, you can figure your maximum deduction for contributions for yourself by completing the following steps.

Deduction Worksheet for Self-Employed

Step 1
Enter the rate shown on line 3 above
Step 2
Enter your net earnings (net profit) from line 31, Schedule C (Form 1040); line 3, Schedule C-EZ (Form 1040); line 36, Schedule F (Form 1040); or line 15a, Schedule K-1 (Form 1065)
Step 3
Enter your deduction for self-employment tax from line 27, Form 1040
Step 4
Subtract step 3 from step 2 and enter the result
Step 5
Multiply step 4 by step 1 and enter the result
Step 6
Multiply $170,000 by your plan contribution rate. Enter the result, but not more than $35,000
Step 7
Enter the lesser of step 5 or step 6. This is your maximum deductible contribution. Enter your deduction on line 29, Form 1040

Example. You are a self-employed farmer and you have employees. The terms of your plan provide that you contribute 8 1/2% (.085) of your compensation (defined earlier) and 8 1/2% of your participants' compensation. Your net earnings from line 36, Schedule F (Form 1040) are $200,000. In figuring this, you deducted your common-law employees' pay of $100,000 and contributions for them of $8,500 (8 1/2% x $100,000). You figure your self-employed rate and maximum deduction for contributions on behalf of yourself as follows.

Rate Worksheet for Self-Employed

1)	Plan contribution rate as a decimal (for example, 10 1/2% = .105)	0.085
2)	Rate in line 1 plus 1 (for example, .105 + 1 = 1.105)	1.085
3)	Self-employed rate as a decimal rounded to at least 3 decimal places (line 1 × line 2)	0.078

Deduction Worksheet for Self-Employed

Step 1
Enter the rate shown on line 3 above	0.078
Step 2
Enter your net earnings (net profit) from line 31, Schedule C (Form 1040); line 3, Schedule C-EZ (Form 1040); line 36, Schedule F (Form 1040); or line 15a, Schedule K-1 (Form 1065)	$200,000
Step 3
Enter your deduction for self-employment tax from line 27, Form 1040	7,663
Step 4
Subtract step 3 from step 2 and enter the result	192,337
Step 5
Multiply step 4 by step 1 and enter the result	15,002
Step 6
Multiply $170,000 by your plan contribution rate. Enter the result but not more than $35,000	14,450
Step 7
Enter the lesser of step 5 or step 6. This is your maximum deductible contribution. Enter your deduction on line 29, Form 1040	$ 14,450

When to make contributions. To take a deduction for contributions for a particular year, you must make the contributions not later than the due date (generally April 15 for calendar year taxpayers), plus extensions, of your tax return for that year.

More information. See Publication 560 for more information on retirement plans for small business owners, including the self-employed. Publication 560 also discusses the reporting forms that must be filed for these plans.

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