We all know about the advantages of cash balance plans. But what about other retirement plans for small business owners?
In this post we take a look at a 412(e)(3) pension plans. They are little known but are a great solution for many business owners.
Not only are we going to examine some of the pros and cons of the plans but also take a look at the FAQs. Few investment advisors or tax advisors understand how they work, so we will try to break down the barrier.
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What are 412(e)(3) plans?
A 412(e)(3) plan is a type of defined benefit pension plan that is funded almost entirely with guaranteed insurance products. Instead of investing plan assets in mutual funds or other market-based investments, the plan buys contracts from an insurance company that promise stated interest and guaranteed benefits. Because the benefits are tied to those insurance guarantees, the plan’s funding is generally more predictable than a “traditional” defined benefit plan that depends on investment performance.
These plans are most common for small, closely held businesses that want a high, stable contribution level and less market volatility in the plan’s funding. Contributions are determined by an actuary, but the underlying assets are the insurance contracts, which reduces uncertainty around expected returns. If life insurance is included, it must follow qualified plan rules on how much life insurance is permitted, and the plan must be structured so retirement benefits remain the primary purpose.
In exchange for the stability, 412(e)(3) plans come with tradeoffs and compliance considerations. Insurance-based funding can be more expensive than other approaches because of commissions, policy expenses, and conservative guarantees, and the plan design can be less flexible once contracts are in place.
Historically, some arrangements were marketed aggressively and drew IRS scrutiny when insurance was used in ways that appeared to emphasize tax benefits over retirement benefits, so careful plan design and administration matter. For the right business, though, a properly designed 412(e)(3) plan can provide a disciplined, guarantee-focused path to funding significant retirement benefits.
How does a 412(e)(3) plan work?
The plan works as follows:
- A qualified third party administrator is chosen and the plan is designed and drafted.
- The plan is funded and acquires qualified annuities and possibly life insurance contracts.
- On an annual basis, the third party administrator provides compliance and reporting services.
- The company will level-fund the plan during the working life of each participant.
- Upon retirement, the promised benefit based on the insurance annuity is utilized by the retiring participant.
What are the advantages of 412(e)(3) plans?
There are many advantages of 412(e)(3) plans:
- They offer stable investments returns without market fluctuations.
- They provide flexibility and security based on the guaranteed insurance contracts.
- Because of the assumed lower rate of return, companies can generally make substantially higher tax deductible contributions compared to traditional defined benefit plans.
- They allow companies to fund larger contributions for older employees that will not increase contributions for younger employees.
- Because they do not require an actuary, they will generally allow for lower administrative costs compared to traditional defined benefit plans.
What are the disadvantages of 412(e)(3) plans?
Some of the disadvantages include:
- Since they use only pension insurance products, the investment returns tend to be lower.
- They can require large contributions, especially in early years.
- They do not allow loans.
- The annual contributions are fixed, so there is no ability to increase or decrease based on circumstances.
- While the plan is open, annual contributions are required and are not elective.
- Even though administrative costs are lower than traditional defined benefit plans, they are higher than 401k plans.
FAQs
What happens when a participant retires?
The participant receives the targeted retirement benefit. Participants may also retain the life insurance benefit by taking the policy as a distribution. In this case, the policy’s fair market value will be deemed taxable income assuming the policy is purchased from the plan. If the participant does not want the life insurance, the policy may be surrendered for its cash value.
Should the participant desire to maintain the life insurance, the policy will be individually owned. Assuming proper estate planning, proceeds may be excluded from estate tax.
What is the difference between traditional defined benefit plans and 412(e)(3) plans?
412(e)(3) plans are only allowed to invest funds in annuity contracts and permanent life insurance. The plans will offer participants a guaranteed return. Defined benefit pension plans are allowed to invest in the same insurance contracts but also can invest in traditional investments like stocks and mutual funds. Defined benefit plans can offer higher returns, but since 412(e)(3) plans offer guarantees they can protect against investment downside.
What is the maximum benefit under a 412(e)(3) plan?
The maximum benefit is adjusted typically annually. Currently, the maximum benefit for a retirement age of 62-65 is the lower of 100% of salary or $18,333 a month. This is then reduced by 1/10th for every year of plan participation less than 10 years.
How are contributions determined?
The company will often determine a targeted retirement amount. Using the guaranteed interest rate and the number of years to normal retirement, the annual premium needed to reach the target is calculated.
Can you borrow from a 412(e)(3) plan?
No. Loans are not allowed under the plan. The rights under the insurance contracts cannot be used as collateral. So, unfortunately, neither the company nor plan participants can borrow under the plan.
Who are qualifying employees under the plan?
Any full-time employees must be covered. Part-time employees who work less than 1,000 hours and union employees can be excluded. In addition, the company can exclude employees younger than age 20 1/2 or who have less than one year of service. Plans can be customized to exclude certain other employees, subject to additional coverage testing.
Is annual funding mandatory?
Yes. The plan is subject to annual funding requirements. But plans can be amended, frozen or terminated if circumstances dictate.
Are contributions to a 412(e)(3) plan tax deductible?
Yes, they are. The plan is a qualified plan and, accordingly, the company can take a tax deduction for contributions made to the plan. Participants are not taxed until the receipt of the benefit.
Can a 412(e)(3) plan be structured to make contributions at a specified level?
Yes. Plan design is critical to success. Company contributions can be established at a rate that the company is comfortable with. Specific scenarios should be run that will allow for the required contribution level.
Can a 412(e)(3) plan be combined with other plans?
Yes. But you must take a close look at the structure of the current plans. The following rules apply:
Is a Cash Balance or Defined Benefit Plan Right For You?
- 401(k). Subsequent to January 1, 2002, a company is allowed to retain its 401(k) plan and also adopt a 412(e)(3) Plan.
- Profit Sharing Plan. The company is allowed to have a profit sharing plan. However, the profit sharing contribution would typically be limited to 6% of compensation if the 412(e)(3) plan is not covered by the PBGC.
- Defined Benefit Plan: Since a 412(e)(3) plan is a form of defined benefit plan, it is recommended that the company terminate any existing defined benefit plan. Any accrued benefit of the prior defined benefit plan would lower the maximum benefit of a new 412(e)(3) plan.
What type of companies can adopt a 412(e)(3) plan?
The plans are available to all business entities, including S-Corps, C-Corps, partnerships, and sole proprietors. Generally, the plans work best for small businesses with minimal employees. In addition, the older the owners the better in order to maximize contributions and take advantage of tax deductions.
Does an actuary sign off on the plan?
Review of the plan by an actuary is not required. Since the benefit is guaranteed by the insurance company, the plan cannot be under funded. As such, there is no need for annual certification by an actuary to state that funding is adequate and to determine annual contributions. This can decrease the cost of annual administration.
Does the plan cost anything to participants?
No. Plan participants do not pay any costs associated with the plan. But if the plan provides a life insurance death benefit, an employee will have taxable income to the extent of current economic benefit. This is calculated using Table 2001.
Can the company take a tax deduction for plan set-up fees and annual administration costs?
Yes. The costs are tax deductible as ordinary business expenses.
How much can you contribute to a 412(e)(3) plan?
The company’s contribution depends on a variety of factors, including primary the ages of it’s employees and the desired targeted benefit amount. Because of the conservative returns association with the insurance guarantees, companies can typically contribute substantially more to a 412(e)(3) plan than a defined benefit pension plan. 412(e)(3) contributions will far exceed any contributions allowed in a 401k or other defined contribution plan.
How safe is a 412(e)(3) plan?
Very safe. Because participant benefits are guaranteed by the insurance provider, the plan essentially has no investment risk.
Final thoughts
412(e)(3) plans can be great plans for small business owners. Unfortunately, most advisors and financial planners are not familiar with them.
We have examined many of the pros and cons and also many FAQs. Hopefully, you are now well versed on how the plans work and can determine if a plan is right for you.
