By Mark Papalia, CLU, ChFC, CFP
Published in the PICPA e-newsletter in November 2003
It is often said that there are no guarantees in life, and that the only things we can be certain of are death and taxes, neither of which is necessarily positive. But what f there was a third certainty; specifically, 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 over the last three years, a plan of that nature would be a welcomed sight. For CPA firm owners and their clients, 412(i) plans offer the type of guarantee that many small employers seek.
Growing Popularity of 412(i) Plans
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. For example, 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. In addition, a sluggish economy and the uncertainty of the stock market have changed investment strategies. Investors are no longer focused on the highest return on their investment, they just want to ensure the return of their investment. 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.
Advantages of the 412(i)
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 into the plan 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 funding of a defined contribution plan. With a defined contribution plan, you can contribute up to $40,000 annually and at the end of a specified period of time, the balance¾depending upon earnings and/or losses¾is yours. But there’s no certainty of what the outcome of your investments will be. The employer assumes the risk on the earnings that those contributions return.
When a 412(i) plan is set up, the small business owner decides how much he or she wants to receive annually upon retirement (the defined benefit) and funds the plan by paying premiums (up to a limit of $300,000 annually) to an insurance company. The insurance company, not the employer, assumes the risk for investing the premiums to meet that end goal and guarantees that the defined benefit will be paid. Therefore, while employers may not earn as much of a return in a 412(i) plan as they may receive from other self-directed investments, they do not bear the level of risk either. Because an employer’s contributions to a 412(i) plan are tax-deductible, there is another advantage to this plan -- the ability to receive an income tax deduction of up to $300,000 annually – and this 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. As a 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? Consider the following checklist as a guide. 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 and/or needs to maximize his or 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 corporation, a partnership or an LLC.
What’s Next?
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, Pa. For more information, contact mpapalia@papaliafinancial.com.
This article was previously published in the Northeast Pennsylvania Business Journal and appears with permission from both the Northeast Pennsylvania Business Journal and the PICPA.
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