412(i) Plans Provide Safe, Fully Insured Savings Option

By Mark Papalia, CLU, ChFC, CFP

Published in the Northeast Pennsylvania Business Journal in October 2003

Benjamin Franklin said the only things we can be certain of are death and taxes, neither being a certainty people appreciate. But what if there was a third certainty--a plan that guaranteed you would receive a specific benefit amount upon your retirement?

For small employers, many of whom lost substantial portions of their retirement assets in the stock market, a plan of that nature would be welcome.

For CPA firm owners and their clients, 412(i) plans offer the type of guarantee that many small employers seek.

A 412(i) plan, also known as a fully insured plan, is a form of defined benefit pension plan that is funded exclusively by life insurance, annuity contracts, or a combination of the two.

The increased popularity of 412(i) plans can be traced to recent tax law changes. Prior to December 31, 1999, Section 415(e) of the Internal Revenue Code mandated that defined benefit plans and defined contribution 401(k) plans had to be grouped together.

The rule linked, and also limited, the amount an employer could fund between the two plans. With the repeal of Section 415(e), an employer could fully fund both a defined benefit plan and a defined contribution plan. The 2001 tax bill increased the retirement benefit from $125,000 to $160,000 per year.

A sluggish economy and the uncertainty of the stock market also have changed investment strategies.

Despite the market enjoying good returns during the second quarter of this year, investors are still nervous about the long-term outlook. And as they move closer to retirement, they want to neutralize the market’s impact on their retirement goals. Because of their guaranteed retirement benefit structure, 412(i) plans are providing that neutralizing effect.

For small business owners age 45 and older, 412(i) plans offer many benefits. Perhaps the most important is that the plan allows significantly greater contribution levels than a regular defined benefit plan or a normal 401(k) plan.

For example, a small business owner may be able to contribute up to $300,000 each year, substantially higher than the $40,000 maximum that can be put in a defined contribution plan.

That difference can be significant for employers who have found that they have a much smaller retirement nest egg due to the downturn in the stock market.

If they previously had $2 million in their plan and now it’s $1 million, they need to put at least $100,000 a year back to return it to where it needs to be. With the normal defined contribution or 401(k) plan, that’s not possible.

Funding for a 412(i) plan is calculated the opposite of how a defined contribution plan is funded. With a defined contribution plan, you can contribute up to $40,000 annually and at the end of a specified time period, the balance (depending upon earnings and/or losses) is yours. But there’s no certain outcome.

When a 412(i) plan is set up, the small business owner decides how much he or she wants to receive annually upon retirement, up to the maximum allowed, and the plan is funded to meet that goal.

And because a third party guarantees all of the benefits, assuming of course that premiums are paid when due, the employer’s risk to principal is zero.

The only risk employers potentially face is the risk of not earning as much return as they might elsewhere.

However, because an employer’s contributions to a 412(i) plan are tax-deductible, the ability to receive an income tax deduction of up to $300,000 annually more than offsets the plan’s more conservative investment strategies.

Another benefit of 412(i) plans is that they are generally easier and less expensive to administer than many other types of retirement plans.

No actuarial certification is required on a 412(i) plan so there are no direct actuarial fees. By comparison, administration costs for a 412(i) plan would generally be less than $1,000. For a traditional defined benefit plan the costs could be between $3,000 and $5,000, or three to fives times the expense of a 412(i).

In addition, because 412(i) plans are normally funded with a mixture of life insurance and annuity contracts, they can provide for disability benefits.

If the life insurance piece of the plan has a waiver of premium built into it, a portion of the funding would continue through retirement age--should the employer become disabled.

When should a small business owner make use of a 412(i) plan? A 412(i) plan makes sense if:

• The owner or key employee is at least 45 years of age,
• The owner or key employee wants/needs to maximize his/her contributions,
• The business has consistent cash flow to benefit from the large tax deduction. 

To qualify as a 412(i), plans must be funded exclusively with guaranteed products, usually annuity contracts or a combination of life insurance and annuities. The contracts must provide for level annual premium payments until the retirement of employees. 412(i) plans are available no matter what type of business structure the employer has, whether a sole proprietorship, a partnership or an LLC.

412(i) plans can be a solid, viable component of a retirement plan no matter what the market conditions. Many employers still have a 401(k) or profit sharing plan that is invested in bonds and stocks, but are adding the 412(i) as the guaranteed investment piece. The reality is that retirement investments--as with all investment strategies--should be properly diversified. And if you’re going to diversify, why not invest in one of the few guarantees life has to offer?

Mark Papalia, CLU, ChFC, CFP, is president and founder of Papalia Financial in Danville. His e-mail is mpapalia@papaliafinancial.com.

Reprinted with permission from the Northeast Pennsylvania Business Journal.