Asset Management, Inc. - Basic Investment Tools

There are many small business owners looking for ways to tax deduct retirement contributions. Most traditional qualified plans impose strict limitations as to the amount of tax-deductible contributions. A 412(i) plan may be an effective way to meet these challenges. A 412(i) plan is a qualified defined benefit plan that is exempt from minimum funding requirements because of its unique funding features. In addition, recent legislation has increased the maximum allowed retirement benefit that can be provided by a qualified defined benefit plan. As an employer, your contributions to the plan should be tax-deductible and, since it is a qualified plan, its assets will grow income tax deferred as long as they are in the plan.

A properly structured 412(i) defined benefit plan is a qualified plan that meets the requirements of Section 412(i) of the Internal Revenue Code. In order to meet these requirements, all benefits under the plan must be guaranteed by a life insurance company. In order to provide these guarantees, the insurance company will use life insurance, annuities or a combination of the two. The maximum tax deductible contribution to a 412(i) plan is usually significantly higher than contributions to other qualified plans due to these guarantees. The plan is actually exempt from minimum funding requirements. The plan defines the amount of the benefit that is to be paid to the participant upon retirement and then must fund to meet those benefits. These calculations should be performed by a qualified plan administrator to ensure that the plan will have enough assets to meet the retirement distribution obligations in the future. These contributions should be tax deductible to the employer at the time of contribution and should not be currently taxable to the participant.

All of this may sound very complicated however, one of the major appeals of the 412(i) is in its simplicity of administration. A 412(i) plan is exempt from many of the complex minimum funding requirements because the contributions are more stable and predictable. Also, due to the fact that all benefits are guaranteed by an insurance company, many of the complicated actuarial computations are avoided. One area to be aware of is what is known as Incidental Benefit Limits or Incidental Benefit Test. These have been described by many practitioners as “safe havens” or “safe harbors.” The “100-to-1” test means that the death benefit cannot exceed 100 times the anticipated monthly retirement benefit. For example, if the anticipated monthly benefit at retirement is $8,000 per month then to meet the incidental benefit test, the life insurance protection would be $800,000. As previously stated, this is a “safe harbor” and not an actual limitation. The other incidental benefit test is what is known as the percentage of benefits test. Here the cost of the ordinary life insurance cannot exceed 50% of the employer’s contribution to the employee’s plan.

Let’s look at an example. A 412(i) plan is established by the owner of a business for his or her employees. The plan is funded with a life insurance policy, a tax-deferred annuity or a combination of the two. Contributions are made to the plan and should be tax-deductible to the employer. The plan then uses the contributions as life insurance or annuity payments. The plan assets grow income tax deferred.

If the 412(i) plan is terminated, the life policy may be distributed to the insured as taxable income. Upon distribution, the income tax valuation of the policy could potentially be the cash surrender value, tax reserves, interpolated terminal reserve or some other measure of the policy’s fair market value. The determination of the income tax value of the policy upon transfer must ultimately be made by the client, in accordance with the advice of his or her tax and legal counsel.

After the life policy has been transferred out of the 412(i) plan and if the insured’s life insurance needs have changed, the insured may wish to 1035 exchange the policy for a different life insurance policy or annuity that better suits his or her needs.

As an alternative to receiving a distribution of the policy, the insured may desire to purchase the life insurance policy from the 412(i) plan with outside funds. The purchase price could potentially be the cash surrender value, the tax reserves or the interpolated terminal reserve. This purchase may be by the insured himself or under properly structured conditions, by a life insurance trust. This could allow the life insurance proceeds to pass to the ultimate beneficiaries income and inheritance tax free.

Another advantageous aspect of the 412(i) is asset protection. We are living in a very litigious society. There is a new lawsuit filed every thirty seconds. A 412(i) Defined Benefit Plan shares the same asset protection rules as 401K, Profit Sharing and other qualified pensions plans.

The 412(i) plan is a unique pension plan that allows large tax deductions, favorable designs and funding flexibility. It is an ideal arrangement for a successful business owner to reduce and defer income taxes. Significant retirement benefits and death benefits can be provided on a guaranteed basis. Section 412(i) has been a part of the Internal Revenue Code for many years and its application is very clear and specific. Recent changes in the rules, however, have made the results considerably more attractive than in the past. These changes along with specifically designed products make the 412(i) more attractive than ever.

Please be advised that neither Asset Management Inc. nor any of its agents give legal or tax advice. This information has been derived from sources which we believe to be reliable but has not been independently verified by us. The opinions expressed herein reflect our current judgment and are subject to change without notice. We recommend that you consult with your tax advisor and attorney for complete details before making any final decisions.

Securities Offered Through Mutual Service Corporation, A Registered Broker/Dealer - Member NASD and SIPC

Asset Management, Inc. is not affiliated with Mutual Service Corporation.

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