The term "pension plan" is now used to describe a variety of retirement programs that companies establish as a benefit for their employees—including 401(k) plans, profit-sharing plans, simplified employee pension (SEP) plans, and Keogh plans. In the past, however, pension plans were differentiated from other types of retirement plans in that employers were committed to providing a certain monetary level of benefits to employees upon retirement. These "defined benefit" plans, which were common among large employers with a unionized work force, have fallen into disfavor in recent years.

Some individuals also choose to establish personal pension plans to supplement their retirement savings. Making sound decisions about retirement is particularly important for self-employed persons and small business owners. Unlike employees of large companies, who can simply participate in the pension plans and investment programs offered by their employers, entrepreneurs must set up and administer their own plans for themselves and for their employees.

Though establishing and funding pension plans can be both time-consuming and costly for small businesses, such programs also offer a number of advantages. In most cases, for example, employer contributions to retirement plans are tax deductible expenses. In addition, offering employees a comprehensive retirement program can help small businesses attract and retain qualified people who might otherwise seek the security of working for a larger company.

The number of small firms establishing pension plans grew considerably during the 1990s, but small employers still lag far behind larger ones in providing this type of benefit for employees. According to a 1998 survey by the Employee Benefit Research Institute, 29 percent of small businesses (those with fewer than 100 employees) offered retirement plans, compared to 83 percent of businesses employing more than 100 workers. Small business owners reported uncertain company revenues, low worker demand, high administrative costs, and complex government regulations as some of the main reasons they did not sponsor retirement plans for their employees.


Small business owners can set up a wide variety of pension plans by filling out the necessary forms at any financial institution (a bank, mutual fund, insurance company, brokerage firm, etc.). The fees vary depending on the plan's complexity and the number of participants. Some employer-sponsored plans are required to file Form 5500 annually to disclose plan activities to the IRS. The preparation and filing of this complicated document can increase the administrative costs associated with a plan, as the business owner may require help from a tax advisor or plan administration professional. In addition, all the information reported on Form 5500 is open to public inspection.

A number of different types of pension plans are available. The most popular plans for small businesses all fall under the category of defined contribution plans. Defined contribution plans use an allocation formula to specify a percentage of compensation to be contributed by each participant. For example, an individual can voluntarily deduct a certain portion of his or her salary, in many cases before taxes, and place the money into a qualified retirement plan, where it will grow tax-deferred. Likewise, an employer can contribute a percentage of each employee's salary to the plan on their behalf, or match the contributions employees make.

In contrast, defined benefit plans calculate a desired level of benefits to be paid upon retirement—using a fixed monthly payment or a percentage of compensation—and then the employer contributes to the plan annually according to a formula so that the benefits will be available when needed. The amount of annual contributions is determined by an actuary, based upon the age, salary levels, and years of service of employees, as well as prevailing interest and inflation rates. In defined benefit plans, the employer bears the risk of providing a specified level of benefits to employees when they retire. This is the traditional idea of a pension plan that has often been used by large employers with a unionized work force.

In nearly every type of qualified pension plan, withdrawals made before the age of 59 ½ are subject to an IRS penalty in addition to ordinary income tax. The plans differ in terms of administrative costs, eligibility requirements, employee participation, degree of discretion in making contributions, and amount of allowable contributions. Free information on qualified retirement plans is available through the Department of Labor or on the Internet at .

The most important thing to remember is that a small business owner who wants to establish a qualified plan for him or herself must also include all other company employees who meet minimum participation standards. As an employer, the small business owner can establish pension plans like any other business. As an employee, the small business owner can then make contributions to the plan he or she has established in order to set aside tax-deferred funds for retirement, like any other employee. The difference is that a small business owner must include all nonowner employees in any company-sponsored pension plans and make equivalent contributions to their accounts. Unfortunately, this requirement has the effect of reducing the allowable contributions that the owner of a proprietorship or partnership can make on his or her own behalf.

For self-employed individuals, contributions to a qualified pension plan are based upon the net earnings of their business. The net earnings consist of the company's gross income less deductions for business expenses, salaries paid to nonowner employees, the employer's 50 percent of the Social Security tax, and—significantly—the employer's contribution to retirement plans on behalf of employees. Therefore, rather than receiving pre-tax contributions to the retirement account as a percentage of gross salary, like nonowner employees, the small business owner receives contributions as a smaller percentage of net earnings. Employing other people thus detracts from the owner's ability to build up a sizeable before-tax retirement account of his or her own. For this reason, some experts recommend that the owners of proprietorships and partnerships who sponsor pension plans for their employees supplement their own retirement funds through a personal after-tax savings plan.


For self-employed persons and small business owners, the tax laws that limit the amount of annual contributions individuals can make to qualified retirement plans, as well as the requirement that qualified plans established by an employer must cover all employees, may make these plans less desirable. "If you're relying on a tax-qualified plan to fund your retirement, it's time to rethink that strategy," Arthur D. Kraus wrote in an article for Small Business Reports. "You may want to use a non-qualified plan to supplement or even replace your qualified savings." Kraus recommended that small business owners consider setting up a personal pension plan to provide a source of income and security in their retirement. These plans have nearly unlimited annual contributions and do not have to be offered to employees. "You can sock away as much money as you want each year and use the plan just to cover yourself—as most small business owners do—or offer it to a few top managers," Kraus stated. "And that's not the best part. You can draw tax-free income in retirement from a personal pension plan."

Establishing a personal pension plan involves purchasing a variable life insurance policy and paying premiums, which basically take the place of annual contributions to a retirement plan. The amount paid in is invested and allowed to grow tax-free. Both the premiums paid and the investment earnings can be accessed to provide the individual with an annual income upon retirement. The only catch is that, unlike qualified retirement plans, the annual payments made on a personal pension plan are not tax-deductible. However, Kraus claimed that the tax savings in retirement often offset the loss of the tax deduction during the working years.

Although other types of insurance policies—such as whole life or universal life—can also be used for retirement savings, they tend to be less flexible in terms of investment choices. In contrast, most variable life insurance providers allow individuals to select from a variety of investment options and transfer funds from one account to another without penalty. Many policies also allow individuals to vary the amount of their annual contribution or even skip making a contribution in years when cash is tight. Another worthwhile provision in some policies pays the premium if the individual should become disabled. In addition, most policies have more liberal early withdrawal and loan provisions than qualified retirement plans. The size of the annual contributions allowed depends upon the size of the insurance policy purchased. "The bigger the policy, the higher the premiums—and thus, your plan contributions," according to Kraus. "The IRS also sets a maximum annual contribution level for each size policy, based on your age, gender, and other factors."

Upon reaching retirement age, an individual can begin to use the personal pension plan as a source of annual income. Withdrawals—which are not subject to income or Social Security taxes—first come from the premiums paid and earnings accumulated. After the total withdrawn equals the total contributed, however, the individual can continue to draw income in the form of a loan against the plan's cash value. This amount is repaid upon the individual's death out of the death benefit of the insurance. "Is a personal pension plan right for you? That depends on whether other savings will meet your retirement needs," Kraus noted. "But given the benefits of the plan—tax-free earnings, tax-free retirement income, protection for your heirs, and even disability benefits—it's clear that this savings strategy is well worth considering."


Battle, Carl W. Senior Counsel: Legal and Financial Strategies for Age 50 and Beyond. Alworth Press, 1993.

Blakely, Stephen. "Pension Power." Nation's Business. July 1997.

Blakely, Stephen. "Small Firm Gap Reflects Lack of Demand." Nation's Business. September 1998.

Connor, John B., Jr. "Pay Me Later." Small Business Reports. July 1994.

Corry, Carl. "Pension Tension Mounts." LI Business News. July 30, 1999.

Crouch, Holmes F. Decisions When Retiring. Allyear Tax Guides, 1995.

Gordon, Marcy. "Pensioners Go Underpaid." Detroit Free Press. June 17, 1997.

Kraus, Arthur D. "A Pension Plan of Your Own." Small Business Reports. March 1994.

Livingstone, Abby. "Ways to Expand Pension Savings." Nation's Business. October 1997.

Martin, Ray. Your Financial Guide: Advice for Every Stage of Your Life. Macmillan, 1996.

SEE ALSO: Employee Retirement Income Security Act ; Retirement Planning

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