How to Terminate or Close a 412(e)(3) Plan: 5 Step Guide

Let me be clear. 412(e)(3) plans can be great retirement structures. Unfortunately, they don’t work well for everybody. Business owners often find themselves looking to terminate or close these plans, but don’t know how to do it.

Some of these plans have been sold as abusive tax structures. Unfortunately, many investment advisors and financial planners have sold these plans to the wrong people. Too often they are not a great fit for client’s retirement funds. Business owners find themselves looking to get out of the plans and set up a cash balance plan.

But you do have options. We spend a lot of time helping clients terminate these plans and establishing other retirement vehicles that are a better fit.

But how do you get out of the plans without getting crushed? What about penalties? Let’s take a closer look at the issue and address the issues associated with closing a plan.

The basics of 412(e)(3) plans

A 412(e)(3) plan is technically a type of a defined benefit plan. But rather than investing in mutual funds, stocks and bonds, the retirement benefits are backed with insurance contracts only. Some folks call these plans fully insured defined benefit plans.

closing 412(e)(3) Plan

The appealing part to many business owners is that the plans offer a guaranteed rate of return. Traditional defined benefit plans may be able to offer higher overall returns, but the 412(e)(3) plan guarantees can offer protection against investment downside. They also have lower administration fees because they don’t require annual sign off from an actuary.

So what are the disadvantages?

There are many advantages to 412(e)(3) plans and they can work great in the right situation. But the downside of the plans must be understood up front. Some of the 412(e)(3) disadvantages include the following:

  1. Because they only allow insurance, returns will tend to be lower than with other investments.
  2. They often are structured with large contributions that reduce flexibility in down income years.
  3. Annual plan contributions will by fixed, so you are not allowed to change contribution levels based on business income.
  4. Annual contributions will be mandatory and are not elective.
  5. You cannot borrow against them (no loans are allowed). This is usually not a big disadvantage, but needs to be noted.
  6. Even though they tend to offer lower annual administrative fees, costs will be higher than 401k plans.
defined benefit plan illustration

But what we see is that clients often don’t like the investment returns and long-term commitment. Traditional defined benefit plans allow for minimum and maximum contributions that simply don’t exist with these plans. Accordingly, you can’t scale up contributions in any given year. They are also often complex and clients just don’t understand how they really work.

Terminate or Close a 412(e)(3) Plan?

So let’s take a look at how to go about closing or terminating a 412e (3) plan. This is our 5-step plan:

  1. Communicate your desire to terminate the plan to the insurance carrier or agent. They may try to talk you out of it. So just make sure that you understand your options. This is especially true if you can’t fund the contributions or if the company is going out of business.
  2. The company should adopt plan termination paperwork. This includes any board resolutions.
  3. Hire a new third-party administrator (TPA) who can work with you on the plan wind down. This includes filing a final 5500 with the IRS. Form 5500s may not have been filed in the past as these plans are often single participant plans with balances below $250,000.
  4. Determine any remaining balance. Coordinate any balances that can be rolled over into a new structure.
  5. Set up new retirement structure. In most situations, this will consist of a cash balance plan and 401k. This will allow for flexible funding levels and the ability to offer a diversified investment plan.

Final thoughts on terminating or closing a plan

Terminating or closing a 412e3 plan is possible. If you find yourself in a plan and are looking to get out of it, all is not lost. You may lose some value on the investment amount, but it may be a wise decision at the end of the day. But don’t worry you do have options. Call us today at 1-844-340-1000.

Paul Sundin

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