The 412(i) Defined Benefit Plan
Funded by Life Insurance and Annuities; Ideal For Small Businesses
While 401(k) plans are popular, only limited contributions can be made to these plans, so they may not be the most sufficient retirement income plan for your small business clients - especially because boomers are planning for 30-year retirements. That's where the 412(i) defined benefit (DB) plan comes in.
As one of the most tax-advantaged vehicles available, the 412(i) DB plan (sometimes called the 412(i) Insured DB plan) is a tax-qualified, pension plan funded exclusively by annuities alone or a combination of annuities and life insurance.
The 412(i) DB plan has been praised by financial advisors as one of the most straightforward retirement solutions. It has all the advantages of traditional DB plans but with simpler reporting requirements and lower investment risks. Here are some additional facts about the 412(i) DB plan:
- It is ideal for C Corporations, S Corporations, partnership, sole proprietorship, and self-employed individuals
- It can only be funded with individual or group life insurance and/or annuity contracts of the same series that use the same mortality tables and rates for all participants. Conservative 412(i) plans typically consist of no more than 50% life insurance and no less than 50% annuity, but more aggressive plans have a ratio of 67% insurance to 33% annuity. Going beyond the 67% insurance share is not recommended.
- The employer funds the plan yearly with specific level dollar amounts without interest. Unlike traditional DB plans, there are no required quarterly contributions.
- Yearly payments are adjusted by interest earned from the annuities or the annuities and insurance policies.
- The amount of the employee’s monthly retirement income is fixed (based on a plan formula) but the payout is guaranteed for life.
- Only the insurance contacts can provide the plan benefits and these contracts must be guaranteed by the insurance company.
- Its cash value can be rolled into other retirement plan options.
- It is ERISA creditor-protected, safe from future lawsuits or possible bankruptcy.
- It can be started late in the tax year and still enjoys full tax benefits.
Although the 412(i) DB plan has been available since 1979, some experts say not too many people are familiar with its value as a tax-advantaged savings tool available for small business owners and other private practice professionals with five or fewer employees. Orthodontists and dentists, doctors and surgeons, real estate and mortgage professionals, consultants, farmers and others who are at least 45 years old are also good candidates.
The 412(i) DB plan can be particularly useful to many graying boomers who are not sufficiently prepared for retirement and whose retirement security is at risk. This is because it permits higher contributions than traditional defined benefit plans as shown in the table below:
| Age of Employee (Retirement Set at 62) | Traditional Profit Sharing Plan | Traditional DB Plan | 412(i) DB Plan |
|---|---|---|---|
| 45 | $41,000 | $80,278 | $164,970 |
| 50 | $44,000 | $133,131 | $258,019 |
| 55 | $44,000 | $211,448 | $395,634 |
| 60 | $44,000 | $236,910 | $450,112 |
Because it provides the largest plan tax deductions allowed by law (generally 100% tax-deductible) employers may find the 412(i) DB plan equally appealing. The rule is a lower assumed rate of return on the investment, the higher the tax deductions.
If life insurance is used to fund the plan—with 2% or 3% return floor—employers are allowed to make considerably larger contributions to 412(i) DB plans than a conventional plan to make significantly higher annual tax-deductible contributions for employees.
However, many financial experts cautions against using 412(i) DB plans primarily for tax deductions. For example, while an insurance funded 412(i) DB plan gives the most tax advantage for the employer, it may not have the same effect for the employee. This set up will work if there are no existing estate tax problems. But when an employee with an estate tax issues dies while his or her life insurance policy is in the 412(i) db plan, the death benefit becomes subject to estate taxes.
Using life insurance to fund 412(i) DB plans can also lead to complicated and costly procedures if the insured decides to retire because the insurance policy cannot be transferred to his or her IRA. The alternative route is to distribute the insurance policy to the employee and then gifted to an Irrevocable Life Insurance Trust (ILIT) or an ILIT could purchase the policy from 412(i) DB plans. This way the ILIT removes the insurance proceeds from the taxable estate. Either way, as mentioned earlier, this requires careful planning.
The 412(i) DB plan has other disadvantages. Due to the large contributions, the plan works best for highly profitable small companies where the owner is about 10 years away from his or her retirement. The employer should also be older than most of the company's limited number of employee. Unlike other investment tools, 412(i) DB plan lacks flexibility since the law dictates it can only be funded with insurance or annuities.
Regardless, the 412(i) DB plan will gain more and more in popularity as the number of boomers grows.
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