L ATELY, 412(I) PLANS HAVE BEEN GEN-erating a lot of buzz–and with the taxbenefits these plans provide to small

business owners, it’s easy to see why. Manyclients may be leery of relying entirely onvolatile stock and bond markets to meet alltheir retirement goals. They would like tohave a portion of the income needed atretirement to be guaranteed by a financiallystrong life insurance company.

A 412(i) plan offers investment guaran-tees not found in traditional defined bene-fit plans, along with initially larger incometax deductions than may be available withother types of qualified plans. Using anannuity and life insurance, a 412(i) plancan be an excellent planning strategy tohelp clients make the most of their quali-fied retirement plans with guaranteed, tax-deductible benefits.

“But I’ve spent the majority of mycareer advising clients to stay away fromlow-interest-earning investments,” yousay. “Why would I want to steer themtoward a 3% insurance and annuity vehi-cle?” Good question. Here are the goodanswers. For the client, the major benefitsare the large up-front tax deductions andguaranteed returns on retirement invest-ment. For the advisor, it’s the opportunityfor long-term money management.

And while the tax deduction elementexists in all qualified plans, what reallymakes a 412(i) plan shine is that it canhelp clients build up money for laterrollover into a profit-sharing plan or IRA.

A 412(i) fully insured plan is a definedbenefit qualified retirement plan fundedexclusively with insurance contracts. For aplan to be considered fully insured for theplan year, it must be funded exclusivelywith annuity contracts or a combination ofannuities and whole life insurance policies,

and it must meet several other require-ments in order to qualify as fully insured.

Because of the annuity and life insur-ance policy guarantees, the fully insuredplan is exempt from standard minimumfunding requirements, so no plan actuaryis needed to certify the plan contributionand related income tax deduction.

While not required, a life insurancedeath benefit can be provided to helpprotect the client’s family if the client dieswhile participating in the 412(i) plan. Forincome tax purposes, the plan participantmust recognize the current cost of the lifeinsurance death benefit protection (thedeath benefit in excess of the policy cashvalue) as measured by IRS Table 2001. Ifthe plan participant dies, this portion ofthe death benefit is received by the benefi-ciary income tax-free, while the cash valueis subject to income tax similar to anyother distribution from the plan.

Compared to traditional defined benefitplans, a 412(i) defined benefit plan allowsfor initially higher plan contributions inthe early years of the plan. By definition,the 412(i) plan is always fully funded,never over- or under-funded, as can be thecase with traditional defined benefit plans.

Finally, with funding of a 412(i) planextended to the tax-filing deadline (ratherthan year end), a client can sign plan docu-ments by year-end 2004, but not fund thefirst contribution until the tax filing deadlinein 2005 (including extensions). This flexibil-ity may help a client manage cash flow bet-ter than a traditional defined benefit plan,which requires quarterly contributions.

The table below illustrates how a clientcould maximize his contributions with a412(i) plan while providing an opportunityfor you to manage more assets.

While the mechanics of a 412(i) plan are

not particularly complicated, it does take ateam to establish and administer the plan.One of the key players is the third-partyadministrator (TPA). However, not all TPAsare alike. They charge different fees for ser-vices, may share in commissions, and mayhave various levels of experience adminis-tering 412(i) plans. Most insurance carriershave a list of recommended TPAs. The TPA,the financial advisor, and the client’s otherprofessional advisors should review theclient’s needs and objectives and develop the412(i) plan accordingly.

The TPA develops the plan proposalbased on the client’s objectives, cash flow,and employee census. Once the clientaccepts the plan, the TPA works with legalcounsel to provide the appropriate plan doc-uments and plan administration annually.

Annual plan administration typically

When 3% Is aGood Return

THE TAX ADVISORTHE TAX ADVISOR

By John Oliver

Pondering DB plans forclients? Don’t forget

the tax and insuranceadvantages offered

by 412(i) plans

How They CompareTraditional Defined 412(i)

Benefit Plan Plan

Cash at age 65 $1,471,328 $2,936,784Interest Assumption 6% to 8% 3% to 4%Actuarial Mortality Current GuaranteedNormal Retire. Age Reasonable Reasonable

Source: The Heritage Group LLC. Assumes plan par-ticipant is 50 years old. Funding for maximum retire-ment benefit allowed at age 65. Participant’s salaryin excess of $205,000.

February 2004 www.investmentadvisor.com

includes calculating the required plan contri-bution and developing reports for the gov-ernment, employer, and plan participants.The plan administrator will also handle newplan participant additions and plan partici-pant distributions. Should the plan ever ter-minate, the administrator will prepare allgovernment-related reports and distributefinal payout amounts to plan participants.

To show the tax benefits of a 412(i) plan,consider this case study. William Esquire, a50-year-old lawyer and sole proprietor,establishes a 412(i) plan and bases his con-tribution on the best three consecutive yearsof his Schedule C income, which was$100,000 a year when there was no 412(i)plan. In year 4, he establishes a 412(i) planand contributes $100,000 to the plan, real-izing $0 in net taxable income. In subse-quent years his 412(i) contributions arereduced because the interest earned on pre-vious contributions exceeded the annuityand life insurance contract guarantees,resulting in greater-than-projected planfunding (see “The Tax Advantages” table).

As business thrives, Esquire can makegreater contributions that result in largerdeductions and lower taxable income.

But what happens to a 412(i) plan if anemployee retires or separates from his orher employer? Depending on terms of theplan, participants may be able to select alump sum equivalent to the participant’saccrued benefit.

Following are various options to investthe lump sum distribution that provideadditional money management opportuni-ties for financial advisors

• When No Life Insurance Protection IsNeeded. If the former plan participant nolonger needs life insurance protection, theplan trustee can surrender the life insurancepolicy, recognizing company-imposed sur-render charges if applicable, and then pay acash lump sum to the plan participant. Theannuity contract could be distributed or itcould be surrendered, also subject to anyapplicable company-imposed surrendercharges. If the annuity contract is distrib-uted, with the consent of the issuing compa-ny, the annuity can be reclassified as an IRA.The plan participant could then roll over thecash from the life policy into the annuity, aseparate IRA, or a profit-sharing plan.

• When Life Insurance Is Needed. Many

former plan participants may still need thelife insurance protection offered by the412(i) plan. Depending on the plan docu-ment, the former participant could:

Roll the life insurance policy into a prof-it-sharing plan. The individual’s employermust sponsor an active profit-sharing plan.Life insurance cannot be the only asset in theparticipant’s plan account, and insurancemust be incidental to the plan’s purpose.

Receive the policy as a plan distribution.The former plan participant would payincome tax on the fair market value of thepolicy at the time of distribution. This valueis unclear at this time and may be the cashsurrender value or the interpolated terminalreserve value, which is typically higher thanthe cash surrender value. Since the individ-ual had been recognizing the term cost of

the life insurance protection as incomeannually, he or she could reclaim these costsas cost basis to the policy.

Purchase the policy from the profit-shar-ing plan. If the former plan participant isparticipating in a profit-sharing plan, thepolicy could be transferred from the 412(i)plan as a tax-free rollover and then sold bythe profit-sharing plan to the plan partici-pant. This is normally a prohibited transac-tion, but Prohibited Transaction ClassExemption 92-6 issued by the Departmentof Labor allows a plan participant and cer-tain other parties to purchase a life insurancepolicy from a qualified plan for its cash sur-render value if certain conditions are met.

Note that an IRA cannot own a lifeinsurance policy, so if an insurance policyis involved in the distribution, it could notbe rolled over into an IRA.

• Change of Policy to Meet New Needs. Insome situations, while the client still needslife insurance protection, the whole life poli-cy used in the 412(i) plan may no longer be

suitable. Many carriers, like Transamerica,offer various options, such as an exchange toa variable life policy or a universal life policy.To meet emergencies or to supplement retire-ment income, the policy owner might accessthis policy through withdrawals and loans.

The insurance company may also offerto protect the client’s insurability by offer-ing a new policy without evidence of goodhealth. This option may be limited to a sur-vivorship policy, which pays a death bene-fit at the second insured’s death. However,evidence of insurability is usually requiredfor the second insured.

The Appropriate UseWho are the best candidates for a 412(i)

plan? They might include the following: 1) Highly paid business owners and

professionals looking to maximize taxdeductions

2) Companies with few or no common-law employees

3) Business owners who can make afinancial commitment to the plan for mul-tiple years

4) Clients who prefer security and guar-antees in part of their retirement portfolioover a fluctuating stock market

As always, all qualified retirement plan-ning strategies—including the 412(i)plan—should be pursued with the adviceof tax and legal counsel.

As an advisor, you might wonder whethera strategy trumpeting a 3% return is valu-able. The 412(i) plan has the potential toprovide the largest possible contributionsand deductions for clients with a short retire-ment timeframe, while generating long-termopportunities for you.

John Oliver is VP, strategic marketing ser-vices, for Transamerica Insurance &Investment Group. He can be reached atjohn.oliver@transamerica.com.

IAIA

The Tax Advantages of 412(i)s Schedule 412(i) Net Taxable

Year C Income Contribution Income

1 $100,000 $0 $100,0002 100,000 0 100,0003 100,000 0 100,0004 100,000 100,000 05 100,000 98,000 2,0006 100,000 95,000 5,000

Source: The Heritage Group, LLC.

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