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 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 the ever declining numbers of 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 are worth the effort for a number of reasons. 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 company that does offer such benefits.

The number of small firms establishing pension plans grew considerably during the 1990s, but small employers still lag far behind larger ones in offering this type of benefit to employees. According to a 2005 Small Business Administration report, fewer small companies (those with 500 or fewer employees) offer any sort of retirement benefits to their employees than do larger firms—35 percent versus 75 percent respectively in 2002. For firms with five employees or fewer, only 11 percent offer a retirement savings program, like a 401(k) or Simplified Employee Pension (SEP) plan.


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 to defined contribution plans are defined benefit plans. These plans calculate a desired level of benefits to be paid upon retirement—using a fixed monthly payment or a percentage of compensa-tion—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 1/2 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 at 800-998-7542, 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, 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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MacDonald, John. "'Traditional' Pension Assets Lost Dominance a Decade Ago, IRAs and 401(k)s Have Long Been Dominant." Fast Facts from EBRI. Employee Benefit Research Institute, 3 February 2006.

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"Retirement Planning: Squeeze on Retirement Savings." The Practical Accountant. February 2006.

Sifleet, Jean D. Beyond 401(k)s for Small Business Owners. John Wiley & Sons, 2003.

U.S. Department of Labor. Employee Benefits Security Administration. "Easy Retirement Solutions for Small Business." Available from Retrieved on 12 April 2006.

U.S. Internal Revenue Service. "401(k) Resource Guide—Plan Participants—Limitations on Elective Deferrals." Available from,id=151786,00.html. Retrieved on 9 March 2006.

U.S. Small Business Administration. SBA Office of Advocacy. Popkin, Joel. "Cost of Employee Benefits in Small and Large Businesses." August 2005.