Abusive 412(i)s led to an Internal Revenue Service crack down, leaving a taint on the reputation of this type of defined benefit plan.
But legitimate versions of the 412(i) can prove quite useful to small business owners and partners in professional practices who need to make up for lost time and dramatically boost their retirement funding.
A 412(i) is a tax-qualified retirement plan that, under IRS regulation TD9223 (finalized in August 2005), must be funded by life insurance and fixed annuities. The employer gets a tax deduction for contributions, which are used to pay premiums on the insurance contract covering an employee. The plan may hold the contract until the employee dies -- or it may distribute or sell the contract to the employee, for example, upon retirement.
"Interest for 412(i) plans is driven by Baby Boomers who have not adequately set aside funds for retirement," says Patrick Smith, director of estate and business planning with The Hartford, in Simsbury, Conn.
These plans are exempt from minimum funding requirements that govern other defined benefit plans. The reason: guaranteed rates of return on insurance and annuity contracts typically run at a low of about 4 percent, so actuarial calculations allow them higher contribution levels.
Under the IRS rule, only 49 percent of the plan's contributions can go into life insurance. The rest must go into annuities that directly benefit the plan participant. The insurance company issuing the contract guarantees a fixed retirement benefit based on the policy's cash value. The life insurance and fixed annuities in the plan must pay guaranteed rates.
Smith of The Hartford says that contributions to 412(i)s can be two to five times greater than contributions to other types of pension plans. For example, a person who is 50 years old making $210,000 wages could put $190,000 into a traditional pension plan. By contrast, his maximum contribution to a 412(i) could be $375,000.
A 412(i) plan is funded to a specific age and can't be funded past that age. But a person can continue to work past age 65. Business owners, however, must take distributions from their plan at age 70 1/2, because this is a qualified plan.
In 2006, a retired 412(i) plan participant would be able to take regular payments of up to $175,000 annually or an equivalent lump sum that could be rolled into an individual retirement account (IRA). Distributions are taxed at the participant's ordinary income tax rate. In addition to rolling the money into an IRA, plan participants can put the proceeds into a joint-and-survivor immediate annuity. Or they can take systematic withdrawals from their 412(i) insurance and annuity policies. The majority of retirees roll the proceeds into an IRA.
Advantages to 412(i) plans include:
- Contributions are in pre-tax dollars.
- The insurance provides a potential death benefit for beneficiaries.
- Life insurance comes with disability protection and a waiver of premium disability rider. Policies that pay dividends may use those dividends as paid up additions.
- A third-party administrator can help set up and administer the plan.
- The employer can claim partial income tax credit for administrative expenses.
- Plan assets are protected from creditors.
But beware: The IRS is on the look out for abusive plans. The IRS can shut down plans if the insurance policy is set up so that the cash surrender value is significantly lower than premiums paid, giving the company a big income tax deduction. Later the contract is sold to the plan participant for the cash surrender value, based on a period in which the cash value was low. The cash surrender value rises substantially, however, after its transfer to the employee.
Even when done on the up-and-up, there is no free lunch with 412(i)s. Roccy DeFrancesco, a St. Joseph, Mich.-based estate-planning attorney, says there are several drawbacks including:
- Insurance policy loans can't be made within 412(i) defined benefit plans.
- Life insurance and fixed annuities may have substantially lower returns than 401(k)s and other types of plans. It may be possible for a business owner to contribute less to a 401(k) plan and achieve the same results due to higher investment returns.
- The more employees an employer has, the less financially viable the plan is, due to ERISA rules that prohibit discrimination in funding plans. DeFrancesco advises using 412(i) plans with businesses of 10 employees or less.
Companies also must watch sources of income used to pay 412(i) premiums, or contributions may not be tax-deductible. For example, a 412(i) can't be funded with passive income. Nick Paleveda, a Bellingham, Wash.-based tax attorney and author of the self-published 412(i) Defined Benefit Pension, says subchapter S corporations can't fund premiums from the business owner's draw. Rather, funding should come from a paid bonus, so that social security and Medicare taxes are paid.
Smith of The Hartford says that companies could pay recapture on deductions if a contract is over funded.
There also may be costly estate tax issues -- particularly if estate tax breaks are allowed to expire in 2010.
Paleveda says an irrevocable life insurance trust may have to be set up to buy the plan participant's 412(i) contract. The maneuver is costly -- the purchase price is based, in part, on the accumulated cash values in the contract.
So how do you make sure a 412(i) is legit?- It must invest 51 percent in a fixed annuity and 49 percent in a life insurance policy that pay guaranteed rates.
- The life insurance policy cannot be set up with springing cash values. The employee must buy out the 412(i) policy at fair market value, not at depressed cash values.
- The lump sum distribution from the plan can be rolled over into an IRA. Other options include: Taking systematic withdrawals from the plan, or investing the proceeds in an immediate annuity that pays lifetime income.
And, of course, it's best to consult with an expert, just to make sure.
Alan Lavine is the author of 16 books, including, with Gail Liberman, Rags to Riches: Motivating Stories of How Ordinary People Achieved Extraordinary Wealth (Dearborn Trade, U.S., 2000).
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