The 412(i) Plan (UPDATE)

An Alternative Defined Benefit Plan

A 412(i)—often referred to as an "insurance contract plan"—is a defined benefit pension plan funded exclusively with annuities or a combination of life insurance and annuities. This may be an attractive alternative to other defined benefit plans if you are a business owner at least 45 years old, and are self-employed or have few employees—particularly if you were unable to save in earlier years and you now wish to make large, tax-deductible contributions.

"A 412(i) plan is simply a defined benefit pension plan where all forms of benefit are guaranteed by a single insurance company whose annuity and life insurance contracts are exclusively used to fund the plan."

Last year's passage of the Pension Protection Act of 2006 made some changes. For example, insurance contract plan rules will move to IRC 412(e)(3) beginning in 2008. But in large part, such plans remain unchanged.

Such a plan can offer the following advantages:

• benefits are guaranteed by the insurer providing the annuities and life insurance, not the employer,
• it is possible to taker larger initial deductions, and
• such plans are relatively easy to administer.

The 412(i) is the only defined benefit plan that is exempt from the minimum funding requirements of Section 412 of the Internal Revenue Code.

Deciding what's right for you

As a small business owner, with the present variety of retirement plans, it can be difficult to determine which one is best for you. A 412(i) defined benefit plan may fit the bill. They offer fully guaranteed retirement benefits and typically generate the largest possible tax deduction for small business.

This type of plan guarantees a fixed lifetime monthly benefit at retirement. What distinguishes a 412(i) from other defined benefit plans is that funding of the plan takes place through guaranteed insurance company annuity contracts or a combination of life insurance and annuity contracts. These contracts guarantee investment return to assure that plan assets will be available upon retirement of the participants, and limits the risk of declining returns on investments.

Characteristics of a 412(i) Plan

• Your business is allowed substantial deductions and you pay no tax on plan contributions until retirement.
• Unlike defined contribution plans, such as a 401(k), there is no limit on the amount that can be contributed in a given year.
• You are able to create a sizable accumulation for meeting retirement goals.
• Your contribution will accumulate on a tax-favored basis since you do not pay tax on earnings during accumulation years.
• You are protected against market fluctuations since all funds are invested in insurance contracts of guaranteed value.
• Your retirement benefits are guaranteed.
• Because it is not a defined contribution plan, performance does not depend on the participant's ability to save.

A 412(i) plan offers two funding options:

One option is a combination of fixed annuity and whole life insurance. The premium is paid by the business and is tax-deductible. The other option is to place all of the contribution in a fixed annuity contract. Your money will grow at the current interest rate but will never earn less than a specific rate guaranteed for the life of the contract.

• Contributions are based on a participant's age, compensation, retirement age, and amount of life insurance coverage.
• 412(i) plans differ from other defined benefit plans in that a plan may roughly double the maximum deductions allowed under a "traditional" plan for first year contributions. This is why such plans are particularly attractive to individuals who were unable to save in early years.

In any given year, the life insurance contract may credit dividends and the annuity contract may pay interest in excess of the guaranteed rate. Any dividends or excess interest earnings are used to fund future year plan contributions. This typically results in reduced contributions over time.

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. Life insurance contracts pertaining to any given participant must be removed from the plan upon the participant's retirement or termination. Generally, the policy may be surrendered for its cash value, distributed to or purchased by the participant, or exchanged for a policy outside the plan.

Insurance contract plans are an exception to the usual funding rules of IRC 412 as, by statute, the present value of the accrued benefit always equals the cash surrender value of the contracts. The guaranteed benefits remove market risk and create greater initial tax-deductible contributions for the plan sponsor.

What happens upon retirement

As stated earlier, benefits are guaranteed by annuities or a combination of annuities and life insurance. Full benefits are payable at normal retirement age and are usually in the form of a monthly figure based on prior compensation and years of service, payable for the lifetime of the plan participant.

You have some flexibility in how you receive distributions from the plan. Some plans may allow for lump sum distributions upon retirement. You could take the accumulated cash and roll the funds into an IRA. This would avoid taxation at the time of distribution and give you future flexibility in pay-out options. Once your funds are in the IRA, you could shop for the best rates and purchase an intermediate annuity to maximize your monthly lifetime pay-out. Alternatively, you could leave the cash in the IRA and begin investing in your choice of investments and defer pay-out to a later date. You pay no tax until you begin withdrawal from your IRA.

If you need continued life insurance coverage, it remains portable, and you may buy your policy from the plan.

If you retire early, you will receive the amount of funds that have accumulated in your guaranteed contracts to that point in time.

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Adapted from 412(i) Plan Overview and FAQ 2007, Security Mutual Life Insurance Company of New York, New York, NY (document 0010752XX, 01/2007); 412(i) Questions and Answers, American National Insurance Company, Galveston, TX, 2005; 412(i) Plan Highlights, American National Insurance Company, Galveston, TX, 2005; Advantages of Life Insurance in Qualified Plans, American National Insurance Company, Galveston, TX, 2005; The 412(i) Plan: The Small Business Retirement Plan with Big Benefits, Guardian Insurance and Annuity Company, New York, NY (publication EB-014233 (3/03))

 For more information, please contact Jonathan E. Brochstein at Weston Wealth Strategies—(203) 319-9876 or contact Jonathan via email.

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