Hello and thank you for your question.
As you may already know, "'Code section 412(i) insurance contracts'
are contracts that provide retirement benefits under a plan that are
guaranteed by an insurance carrier. In general, such contracts must
provide for level premium payments over the individual's period of
participation in the plan (to retirement age), premiums must be timely
paid as currently required under the contract, no rights under the
contract may be subject to a security interest and no policy loans may
be outstanding. If a plan is funded exclusively by the purchase of
such contracts, the otherwise applicable minimum funding requirements
of section 412 of the Code and section 302 of ERISA do not apply for
the year and a Schedule B is not required to be filed."
Instructions for Form 5500
http://www.irs.gov/formspubs/page/0,,id%3D10537,00.html
The last sentence quoted above is important. Section 412(i) plans are
defined benefit plans. Unlike defined contribution plans (which
specify an annual contribution formula, and the employee's retirement
benefit depends on the investment yield of the accumulated
contributions), defined benefit plans define the retirement benefit,
and it is the employer's obligation to make sufficient annual
contributions to fund the promised benefit. So in the usual defined
benefit plan, the plan trustees must hire an actuary to tell them hom
much it is needed for each year's contribution to sustain the promised
benefit. Code Section 411(b)(1)(A),(B) and (C) provide the mimimum
funding requirements needed to sustain the promised retirement
benefit, and Schedule B to Form 5500 is where the actuary provides
assurances to the IRS that the plan is being funded adequately.
Defined benefit plans often call for a bigger contribution - - and
hence a bigger tax deduction - - than do defined contribution plans.
Employers have shied away from defined benefit plans in recent years,
however, because if the plan investment yields prove disappointing,
the plan becomes 'underfunded' which obligates the employer to
contribute additional money in later years to support the promised
benefit. And in any defined benefit arrangement, the age and wage
profile of the employee participants will determine not only HOW BIG
the annual contribution will be, but also WHICH EMPLOYEES will ddraw
the greatest benefits from the plan.
A 412(i) plan allows the employer simply to makes its defined benefit
retirement plan contribution in the form of insurance premiums set by
an insurance company, and the insurance company annuity contract
provides the promised benefit. This makes the contribution aspect of
the defined benefit plan much easier for the employer to comply with.
There is an excellent discussion of the pros and cons of 412(i) plans
authored by Christopher M. Riser of the Riser Report, at
http://www.riserreport.com/Archives/rr1102.htm#412(i)
I cannot set it out here in full because of copyright considerations,
but I suggest you give it a close reading. Mr. Riser makes the
following points:
Advantages:
"There are no limitations on contributions other than the amounts
required by the insurance and annuity policies to fund the plan. So,
for example, if the particular insurance and annuity contracts used to
fund the plan require $400,000 premiums, the allowed contribution and
attendant deduction is $400,000. This generally means that MUCH
larger contributions are allowed than with traditional defined benefit
plans, and MUCH MUCH MUCH MUCH MUCH (get the idea?) larger
contributions are allowed than with defined contribution plans.
There can be no possible overfunding or underfunding of the plan as
long as it stays a 412(i) plan. The plan will be adequately funded
for retirement and won't be subject to IRS penalties to which other
types of defined benefit plans might be if overfunded.
The assumptions underlying the plan funding are those guaranteed by
the insurance company, so the plan should hold up to IRS scrutiny with
no trouble.
The plan is protected from the claims of creditors under the
Employment Retirement Income and Security Act (ERISA), one of the
strongest means of protecting assets.... 412(i) plans can be
excellent asset protection vehicles because because 412(i) plans can
often allow for quick funding with large amounts of cash.
Benefits are guaranteed by the insurance company, which means;
The insurance company bears the investment risk.
The benefits are not affected by market fluctuations.
The guaranteed rates of return are almost always conservative,
which means that high premiums likely will be required in the early
years of the plan, which also means high deductions and the ability to
protect large amounts of assets from creditors' claims.
It is possible to completely fund in a short period of time all of
the benefits under the plan...."
For disadvantages, Mr. Riser offers the following:
"No investment control by the participant (although the plan assets
can later be rolled into a self-directed IRA)
There is no flexibility in the amount or timing of the premiums
which fund the plan; and
No loans are allowed."
Mr. Riser also cautions that the employer beware of abusive plans with
assumptions that simply don’t make sense (the article gives an example
of what that abuse might be).
Here's another review of the plusses and minuses of 412(i) plans, hot
off the press ("last modified March 07, 2003")
Tony Novak, MBA, MT, 412(i) Pension Plans for Business Owners
http://www.medsave.com/_disc1/0000000d.htm
Mr. Novak's article has the same list of advantages, and adds a
possible disadvantage:
"There is a good chance your accountant and pension attorney has
never handled an annuity plan for a small business.
If you set up an annuity plan, you are on your own as far as design
and client support.
Secondly, there are likely to be clarifications on the use of
variable products in regard to annuity plans. It seems clear that the
IRS not foresee the dynamic growth in the use of variable and hybrid
annuity products when the 412(i) regulations were developed.
Clarifications could restrict the liberal use of these products in
annuity pension plans."
Here are two other sources that cover the same ground:
Larger Deductions and Guaranteed Pension Payouts
http://www.nysscpa.org/trustedprof/archive/1202/1Tp11a.htm
412(i) Defined Benefit Pension Plan--The Hottest, True Leverage
Pension Plan of the Times
http://fsc.fsonline.com/fsj/articles/040102leag.shtml
On balance, then, a prudently designed 412(i) plan provides an easy
way for an employer to provide a defined benefit pension benefit. And
if the employee census in terms of AGES and WAGES is appropriate, a
defined benefit plan can provide a valuable tax deduction as each
yearly contribution premium is paid.
Let's close with the principal drawback and concern. 412(i) plans are
INSURANCE plans, which means they bear all the benefits (fixed
premiums, centralized administration, institutional-type investments)
and all the and all the disadvantages we've come to expect from
insurance (commission and profit loads on premiums--especially in the
early years), uninspired investment strategies, and the occasional
collapse of the insurer.
John McKean, J.D.,CLU,ChFC, is opposed to 412(i) planning for that
very reason:
A Competitive Tool
http://www.financial-planning.com/wwwboard13/messages/1148.html
"The assumptions for a 412(i) plan are derived from the guarantees
in the underlying contract(s). Because the guarantees are so low
resulting in low return assumptions, the early funding years require
much higher contributions. The ultimate benefit is the same. All
products must be fixed annuities or fixed annuities with permanent
life insurance. NO EQUITY INVESTMENTS OF ANY KIND ARE ALLOWED
INCLUDING VARIABLE ANNUITIES.
The reason funding is so high early on is because the return on the
underlying products is so poor. These plans are from the dark ages and
are GENERALLY not in the best interests of the client from the
perspective of funding a pension plan. There are really only a few
insurance companies still promoting this type of program. Most have
moved on to the 20th or 21st centuries.
The big sales pitch is to get a bigger contribution and a bigger tax
deduction. You can fund the same benefit for less cost with a
traditional DB plan."
Finally, I will note that Answers and comments provided on Google
Answers are general information, and are not intended to substitute
for informed professional, tax, legal, investment, accounting, or
other professional advice. But if a defined benefit plan suits your
employee age and wage profile, and if you find a quality company
offering a reasonably priced contract, then a 412(i) plan may be just
right for you.
Search terms used:
"412(i)" site:irs.gov
"412(i)" risk
Thank you again for your question. If you find any of it unclear,
please request clarification. I would appreciate it if you would hold
off on rating my answer until I have an opportunity to respond.
Sincerely,
Google Answers Researcher
Richard-ga |
Clarification of Answer by
richard-ga
on
13 Mar 2003 14:10 PST
Hello again:
Here are my answers to your further questions:
--Negative comments about 412(i) pension plans have been made by the
IRS [and] what, if anything, they find objectionable about 412(i)
plans.--
No, I'm not aware of nor have I found any negative IRS comments.
Unlike most areas of the tax law, dealing with the IRS in pension
matters is very straightforward. The 412(i) plan document that the
employer signs (like any 'qualified plan' document) is submitted to
the IRS for approval, and the IRS issues a 'determination letter'
confirming that the plan is tax-qualified. As long as the employer
and trustees administer the plan according to its terms, they have
nothing to fear. [Chances are the insurance company will have
submitted the plan document and obtained IRS approval called a
'prototype plan' even before the employer signs it, and you'll have
your determination letter in hand the day the employer signs the
adoption agreement].
--For instance, I know that the IRS doesn't like it if the plans are
designed to last less than 5 years. They do not feel the plans are
legitimate if the plan terminates in just a few years.--
You're right that if you go to terminate a pension plan within 5
years of its establishment then when you ask the IRS for another
determination letter, i.e. a determination that the termination was
proper and the funds in the plan retain their tax deferred status for
IRA rollover etc., they may give you a hard time and ask you to prove
that when you set up the plan you fully intended it to have a long
life and that the termination came about from changed or special
circumstances like the employer going out of business. But that's not
unique to 412(i) plans.
Likewise if the plan is underfunded when you go to terminate it
there are special rules to make sure that the highly compensated
employees bear the loss [and that's a significant risk in the 412(i)
context through no fault of the IRS but simply because the annuity and
life insurance contracts will probably have poor cash value at that
point in time]. But no, I wouldn't worry that the IRS will be
particularly disapproving of this type of plan.
--I also know that the IRS does not like plans that contain more than
roughly 50% life insurance. Plans that have been structured to
contain 100% life
insurance will be disqualified, or so I am told.--
That's called the 'incidental benefit rule', the idea being that if
a plan is loaded with life insurance then it's not really the retired
employee who will get the benefits during his or her retirement years;
rather the employee's heirs will get the bulk of the money after the
employee's death:
"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
[not exceed] $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."
http://www.assetm.com/wealthaccumulation/412(i)-Introductory%20Article.htm
Section 412 (i) plans are nowhere near funded 100% with life
insurance. They are funded mostly with annuity contracts that start
to pay at retirement age so it shouldn't be hard for the plan to be
structured so as not to violate the incidental benefit rule. It's a
numerical test and I would expect the insurance company that puts the
plan together to make sure there's no violation.
I hope you find this helpful. I continue to feel that the only
significant risk of 412(i) plans is that the contracts may be priced
so that too much $$ goes to the insurance company for its profits and
commissions, leaving too little for the retirees. So look closely at
the policy projections and guarantees before you sign on....
Cheers!
Richard-ga
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