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Summary
Defined Benefit Plans
Only qualified retirement plan to provide employees with a guaranteed retirement benefit payable at normal retirement age, with reduced benefits payable at an earlier retirement date.
Benefit is usually a monthly benefit based on compensation and years of service, and payable for the lifetime of the participant.
Plans may allow for "cash out" at retirement, with participant receiving a single lump sum instead of monthly payments.
Employer has obligation to make necessary contributions. Premiums may be paid to the Pension Benefit Guaranty Corporation to insure the benefits.
412(i) plan
A 412(i) plan is a defined benefit retirement plan whose funding requirements fall under Internal Revenue Code Section 412(i). If a plan meets the requirements of this subsection, it is exempt from the complex funding rules of Section 412 of the IRC applicable to all other defined benefit plans.
Since the passage of the Tax Reform Act of 1986 and the Omnibus Budget Reconciliation Act of 1987, the small business owner has lost interest in defined benefit plans.
A "fully insured" 412(i) plans provides an attractive alternative solution offering simplicity, maximum current tax-deductible contributions and guaranteed retirement benefits.
Features
A "Defined Benefit 412(i) plan" is a special type of defined benefit pension plan, with three significant characteristics:
- Fully Guaranteed Retirement Benefit
- Must be funded with Life Insurance or Annuity Contracts
- Typically generates largest possible tax deduction
412(i) Plans are ideally suited for the small business employer with few employees.
In addition to providing funding for future retirement income, tax deductible 412(i) contributions reduce current taxable income.
Self employed individuals, with expectations of stable future income, may find the features of the 412(i) attractive.
Business owners, starting a second career, should give consideration to the creation of a 412i Defined Benefit Plan.
Additional protection for family and heirs may be provided with the addition of an insured death benefit to the plan.
Requirements
In order for a plan to qualify under Section 412(i), certain requirements must be met:
- The plan must be funded solely with life insurance and annuity contracts that are part of the same series and use same mortality tables and rate assumptions for all participants.
- Insurance contracts must fund benefits using level premiums for all benefits. Payments begin when a participant enters the plan and may extend no later than the retirement date specified under the plan.
- Plan benefits must be provided only by these contracts and be guaranteed by an insurance company. In effect, the plan is "fully insured."
- Participants may not take loans.
Advantages
A "fully insured" plan can provide substantial retirement benefits under this simple and secure program. The accrued benefit for participants is simply the cash value of all life insurance and annuity contracts. It provides a maximum current tax deductible contribution for the business. Some of its other advantages include:
- No full-funding limitation under ERISA Section 404(a)(1)(A) or current liability test to limit contributions.
- There can be no over-funding.
- There can be no under-funding. Contributions are based solely on the guaranteed provision of the level premium contracts.
- No actuarial certification required.
- Substantial administrative savings.
- No quarterly contributions are required, unlike a traditional defined benefit plan; the "fully insured" model may be funded annually without having to pay interest.
The 412(i) plan may not be the ideal plan for all situations and businesses. It works best when there are few employees and where the owner is at least fifty years old or within 10 years of retirement and is older than any of the firm's employees.
How 412(i) Works
When compared with other types of defined benefit plans, larger current contributions are created with a 412(i) plan. Life insurance and annuity guaranteed assumptions are conservative. A Traditional Defined Benefit Plan will have an interest rate assumption much higher than the guaranteed interest rate in a "fully insured" plan. The lower the plan assumptions, the higher the required contribution.
Investments and Gains
It can be expected that some insurance contracts may earn interest above the guaranteed rate. Dividends may be paid on "participating" life insurance contracts. Both dividends and interest in excess of the guaranteed rate will decrease the employer's contribution in a following year. It should be noted that life insurance dividends for all defined benefit plans must be used to reduce the premium.
Such gains will tend to increase over time, essentially lowering the cost of the 412(i) plan. Therefore, if all else remains unchanged, the "fully insured" plan's tax-deductible contributions may be greater in the early years. In contrast, due to limitations imposed by the Omnibus Budget Reconciliation Act of 1987 (OBRA), the funding costs for traditional defined benefit plans will often tend to increase over time.
Contributions for traditional defined benefit plans fluctuate due to actuarial and investment experience. To ensure minimum funding standards are met, an enrolled actuary is required to certify the plan each year. Investment rates are not known and can vary greatly over time. It is this type of variability that can cause a traditional defined benefit plan to become over-funded (a higher investment return than expected) or under-funded (not enough contributions, given the actual investment return and benefits paid.)
A 412(i) plan needs no actuarial certification, as only enough money to provide the guaranteed benefits can be paid to the plan. There can be no over-funding or under-funding problems.
Top Heavy Rules
A "fully insured" plan is subject to the same maximum benefit limitations and "top heavy" provisions as a traditional defined benefit plan.
Maximum Benefit Limitation
The ERISA section that limits the overall plan benefit is known as the "415 limit." Section 415 applies to all defined benefit plans in the same way. It dictates the maximum retirement benefit. Currently, this provision limits a defined benefit plan to a maximum of $160,000 of annual income. This amount is reduced if the actual retirement age is less than Social Security retirement age.
A common technique used to increase the ultimate retirement benefit beyond the Section 415 limit is to roll the lump sum value of the retirement benefit into an Individual Retirement Account (IRA). Before this can be done, however, the lump sum benefit to be rolled out of the plan would need to comply with the Section 415 benefit accrual limit and the provisions of the Retirement Protection Act of 1994 (RPA '94), a provision within the General Agreement on Tariffs and Trade (GATT) treaty.
RPA '94 specifies that the maximum lump sum distribution must be calculated using the GATT-provided mortality table and an indexed interest rate that may be set higher than the 412(i) guaranteed interest rate. These provisions may reduce the amount that may be taken in the form of a lump sum distribution when compared to pre-GATT provisions. It should be noted that this will only affect benefits that are taken in the form of a lump sum and only as they approach the Section 415 maximum dollar limit.
Wealth Preservation Strategies sometimes suggests minimizing this lump-sum distribution problem by using a plan designed to initially be below the Section 415 limit, with the expectation that the lump sum will be rolled out of the plan into an IRA. Even with this reduced limit, the "fully insured" plan provides a much larger current deduction when compared to a traditional defined benefit plan.
Life Insurance
To maximize the available benefits of a 412(i) plan, the participant may elect to purchase life insurance under the plan.
Life insurance in all qualified retirement plans must comply with the "incidental insurance" rules discussed in Treasury Reg. Section 1.401 (b)(1)(i). These provisions place a limit on the amount of life insurance that may be purchased under the plan. Generally, a defined benefit plan can provide no more than 100 times the projected monthly retirement income as a pre-retirement survivor benefit. An alternative provision under Rev. Rul. 74-307 instead allows up to one half of the level premium to be used to purchase life insurance contracts within a defined benefit plan.
While life insurance does not need to be offered under a 412(i) plan, this feature does provide important additional benefits for a participant. If there is an insurance need, the participants may obtain the benefits of life insurance on a pre-tax basis. For highly profitable, closely held businesses, there often exists a substantial insurance need for the owner. A "fully insured" plan cannot only maximize the current deductions, but can also meet these needs by funding the benefit with life insurance contracts.
Taxable "Economic Benefit"
When life insurance is included inside a pension plan, the participants must recognize as a taxable cost the "current economic benefit" provided by the plan (IRC Section 72(m)3(B), Reg. Section 1.72-16(b)). Each participant is then taxed currently on the cost of the "pure" life insurance benefit. The cost of this current benefit is known as the P.S.58 cost. The cost is often determined by using the one-year term rates published in Rev. Rul. 55-747.
Overcoming the $40,000 Limit
Defined Contribution plans, especially 401(k) plans, have enjoyed tremendous popularity over the past 10 years. Now some employers are shifting toward defined benefit pension plans that deliver guaranteed benefits and large tax deductions.
Successful small business owners and professionals are expressing renewed interest in insured fully guaranteed defined benefit plans to assure enough money is set aside at retirement.
Recent pension legislation now encourages this by, permitting much higher tax deductions than defined contribution or 401 (k) plans. Employers are no longer be restricted in what they can contribute to a Defined Benefit Plan due to participation in a prior Defined Contribution Plan.
Conclusion
A 412(i) plan is simple and may perhaps be the ideal plan for the owner of a small business or professional enterprise who desires to maximize his or her current tax deduction and secure guaranteed retirement income. The contributions are, by design, quite large in the early years of the plan. The 412(i) may be less appealing as the number of plan participants increases.
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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