Pension Plans

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.

PERSONAL PENSION PLANS FOR INDIVIDUALS

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, may make these plans insufficient as a sole vehicle through which to save for retirement. A non-qualified plan can be used to supplement retirement savings plans for business owners. Broadly defined, a nonqualified deferred compensation plan (NDCP) is a contractual agreement in which a participant agrees to be paid in a future year for services rendered this year. Deferred compensation payments generally commence upon termination of employment (e.g., retirement) or pre-retirement death or disability.

There are two broad categories of nonqualified deferred compensation plans: elective and non-elective. In an elective NDCP an employee or business owner chooses to receive less current salary and bonus compensation than he or she would otherwise receive postponing the receipt of that compensation until a future tax year. Non-elective NDCPs are plans in which the employer funds the benefit and does not reduce current compensation in order to fund future payments. Such plans are, in essence, post-termination salary continuation plans.

Establishing such a plan can be done in a number of ways. A variable life insurance policy is one way to structure the plan. A company purchases a variable life insurance policy for each participant and paying premiums for the policy annually. 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.

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 insurance policy, the higher the premiums will be, and the higher the contributions. The IRS does set a maximum annual contribution level for each size policy, based on the beneficiary's 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.

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