Everywhere I turn, Section 412(i) plans are the latest topic of discussion. What are they, and why have they become so popular?
Section 412(i) plans are defined benefit pension plans, also referred to as "qualified plans." There are two general kinds of qualified plans: defined contribution and defined benefit.
A defined contribution plan enables one to set aside 25% of earned income, up to $40,000. Meanwhile, a defined benefit plan, such as the Section 412(i) plan, requires one to deposit the amount necessary to fund the promised (or defined) benefit. These annual contributions can be up to $350,000 and are deductible against current taxable income.
If that's not enough, many more benefits arise from Section 412(i) plans. I'll examine some of these benefits so producers can consider whether Section 412(i) plans might be right for prospects:
o Many prospects have suffered losses in the financial markets. In most cases, these losses have been substantial. Internal Revenue Code Section 412(i), however, requires that all contributions made into the Section 412(i) plan go to guaranteed life and annuity products issued by a life insurance carrier. This means whole life insurance products and fixed annuities. So what's the benefit?
The prospect's principal is guaranteed; there will be no more worrying about market losses. With the recent decline in financial markets and so many prospects having to put off retirement due to market losses, it's comforting for prospects to know that there is no market risk in this plan.
o Contributions to Section 412(i) plans are tax-deductible. This applies to S corporations, C corporations, partnerships, and proprietorships. Because every plan receives a favorable determination letter from the Internal Revenue Service (IRS), prospects have a letter that verifies that the plan meets the regulatory requirements, guaranteeing that deductions are assured.
This means that there are no worries about whether the deductible contributions will come back to "bite" the prospect. And everyone has read about the large accounting firms getting into trouble with the IRS over aggressive tax shelters. No worries here! The plan contributions are approved in advance.
o Another aspect that is beneficial is asset protection. The Employee Retirement Income Security Act of 1974 (ERISA) says that pension benefits are "inalienable and non-assignable." This means that a plan participant cannot have his or her benefit taken away by a judgment creditor or pledged as collateral.
o The invested monies grow on a tax-deferred basis. Here's how it works: A Section 412(i) plan is a qualified plan. Qualified plans are trusts specifically tax-exempt under federal regulations. As long as the money is inside the Section 412(i) plan, there is no taxation on the earnings. How much can prospects accumulate in this plan? The method of calculating the payout is beyond the scope of this article, but in general terms, the most someone can accumulate is $2 million -- not an insignificant amount by any measure!
Let's take a look at how a Section 412(i) plan can benefit prospects:
o They can achieve substantial tax-deductible contributions.
o The plan has written approval by the IRS.
o Contributions grow on a tax-deferred basis.
o Invested assets are not subject to market fluctuations.
o Invested assets are protected from judgment creditors' claims.
o Accumulated assets are eligible for a tax-free IRA rollover.
As mentioned earlier, the Internal Revenue Code requires that plan assets be invested in guaranteed return life insurance or annuities. This is another advantage.
Where else can prospects purchase their life insurance using a tax-deductible option?
Additionally, if prospects pass away prior to retirement, the life insurance in the plan enables self-completion of all, or nearly all, of the money that would have been available at normal retirement age. This insured death benefit, to the extent it exceeds the cash surrender value, is received income tax-free by the beneficiaries.
Now that we've examined the advantages of Section 412(i) plans, let's look at the profile of a candidate for this plan. The ideal candidate is 45 or older with few employees; he's someone with significant recurring income and the desire to shelter it from taxation.
But producers shouldn't limit themselves to those prospects older than 45 with two or three employees. It will work with other company profiles; they simply have to be looked at carefully.
So what is the best way to sell Section 412(i) plans to prospects? I went through my files and spoke to all my clients that met the above criterion. Here is what I said: "Mr. or Mrs. Client, you've asked me to help you pay less in taxes, accumulate wealth, and protect your assets from judgment creditors. I may have just the solution for you. Would you like me to tell you more?"
For those who answer affirmatively (and clients almost always do), I tell them that Section 412(i) has been in the Internal Revenue Code for almost 30 years and addresses a certain kind of pension plan -- a kind of defined benefit plan.
And then I tell the prospects why I think it's of benefit to them. It allows for:
o Large annual tax-deductible contributions -- sometimes as much as $325,000.
o Assets protected from claims of judgment creditors under federal law.
o Assets protected from market fluctuations because they are invested in fixed annuity or life insurance contracts issued by a licensed insurance carrier.
o A 3% minimum guaranteed return with the annuity or life insurance product. This is better than most safe alternatives. (Producers should be sure to know the correct return for their products.)
o Up to $2 million accumulation with this plan.
o The rolling over tax-free to an IRA of all money accumulated, up to prescribed limits. (This is so good that the IRS limits how much we can accumulate.)
I then explain how the plan is set up to expect similar, ongoing contributions each year and tell them how they should feel comfortable with that scenario.
There are unfavorable aspects, however, that should be disclosed fully to the prospect. While the following is not exhaustive, here are some detriments to Section 412(i) plans:
o Participant loans are not allowed.
o There is no flexibility in investment choices.
o Annual contributions are required, in addition to annual fees incurred to administer the plan.
o Too many employee participants can skew the cost. If there are plans to add more employees soon, the facts should be considered carefully.
Next I explain the fee structure.There are costs for setting up the plan document and preparing the annual forms, reports, and employee statements. Producers should get these prices from their third party administrator (TPA) to ensure they are quoting accurate numbers.
These plans must be set up by the last day of the prospect's fiscal year to qualify for the tax deduction.
Caution
When preparing Section 412(i) plans, producers should use discretion. Many practitioners are doing designs that simply don't work. Some examples are:
Example 1 -- 100% of the annual Section 412(i) plan deposit goes to life insurance.
Problem -- Revenue Ruling 74-307 says that if more than 50% of the contribution goes toward whole life premiums, the death benefit will not be "incidental." This can cause the plan to lose its qualification status.
The argument by proponents of 100% life insurance is that it is an issue only on payout of the benefit at death. How is it handled? The deceased participant's beneficiary receives only the death benefit that would have been payable under Rev. Rul. 74-307.
What happens to the excess death benefit? It's paid into the Section 412(i) plan. The problem? There is so much money in the plan from death benefit proceeds that it never can be paid out in benefits, so it reverts to the client's business and is subject to federal and state income taxes, in addition to a 50% excise tax.
Example 2 -- Illustrations exclude participants because they are covered under another plan, specifically an employee-only deferral Section 401(k) plan.
Problem -- Some techniques allow for two plans to coexist and one plan to offset benefits in the other, but this particular design won't work as illustrated. Here's why: The Section 401(k) plan is an "employee deferral only" plan.
We can't exclude employees from the Section 412(i) plan simply because they defer their salary without employer contributions to a Section 401(k) plan.
Example 3 -- The benefits illustrated do not match the formula.
Problem -- A Section 412(i) plan is a defined benefit plan and must have "definitely determinable benefits" -- it must have a mathematical formula that defines the pension benefit.
It's amazing, but we frequently see illustrations that don't match the formula, almost as if numbers have been plugged to make the illustration appear better. What does this practitioner do when it is time to install the plan? How does he or she explain the discrepancies between the first-year valuation and the illustration from which the plan was sold?
So what's the point? Producers should be careful of the TPA that they choose to do their clients' work. They should try to find one that employs an enrolled actuary and a pension attorney. They are the more responsible TPA firms that stay away from the "cowboy" designs.
Example 4 -- Benefits exceed IRS limits.
Problem -- Benefits paid from a Section 412(i) plan are limited by the rules set forth in IRC Section 415. Any portion of a participant's benefits that exceeds this limit cannot be paid to the participant and either must revert to the employer or must be reallocated to other participants. Again, money that reverts to the client's business is subject to federal and state income tax plus a 50% excise tax.
The Section 415 limit calculation is extremely important because it plays a major role in the exit strategy. These calculations can be complicated, and we often see illustrations that don't calculate the limit correctly or do not account for the limit in their exit strategies.
Again, producers should try to find a reputable TPA that employs an
