A very hot business-planning topic today is the 412(i) qualified retirement plan. The reason is, these plans are providing exceptionally large tax deductions for contributions to a qualified plan.
What’s behind the buzz is the subject of my article today. Before exploring this plan, let’s review what 412(i) plans are and are not.
A 412(i) plan is a defined benefit qualified retirement plan. It is based on section 412(i) of the Internal Revenue Code. The IRC mandates that these plans must be funded with insurance contracts, either life or fixed annuity, guaranteed by an insurance company.
While such plans are subject to the normal rules that govern other defined benefit plans, the contributions for older employees can be considerably higher than allowed for in traditional defined benefit and/or defined contribution (401k profit sharing) plans. This is because the benefits can be funded using the minimum guaranteed interest rates of life and annuity contracts. This lower minimum guaranteed rate generates significantly higher tax deductions
Now, for what 412(i) plans are not: They are not 419 plans or VEBA (Voluntary Employment Beneficiary Associations) plans, both of which have come under a great deal of IRS scrutiny.
Who will most benefit from a 412(i) plan? In general, small businesses with twenty (20) or fewer employees are best suited for these plans, with one or two person businesses being ideal. Excellent prospects are high earning small business owners, doctors and real estate agents who have relatively stable and predictable earnings.
Note: Larger firms can benefit from 412(i) plans as well, but the plans are not as attractive for them because contributions to such plans must be made for all employees.
412(i) plans have been around for over 40 years, but they fell out of favor when the 1990’s bull stock market made defined contribution plans look more attractive, due to the high investment returns they were generating in the market at that time.
Today’s uncertain economy and stock market, has brought 412(i) plans back into favor; and they are now more popular than ever. The benefits they offer – dramatically increased tax deductions and secure guaranteed investment results – are exactly what business owners are looking for right now.
What’s more, the Economic Growth and Tax Relief Reconciliation Act of 2001 has created the potential for even higher contributions and deductions in all defined benefit plans, including the 412(i) plans. This, too, has helped to make these plans more attractive than ever.
How so? EGTRRA introduced several changes that have combined to boost tax deductions for business owners sponsoring 412(i) plans. The EGTRRA changes include: an increase in the maximum compensation used to determine benefits from $170,000 to $200,000; an increase in the maximum dollar limit for pensions from $140,000 to $160,000; and removal of any reduction on the dollar limit on benefits for participants retiring between age 62 and 65.
Today 412(i) plans provide clients, especially older clients, the largest contribution to a qualified plan, bar none!
For example, a 55-year-old consultant, using a retirement age of 62, could make a maximum contribution of $42,000 into a traditional profit sharing plan; or a $188,209 maximum contribution into a traditional defined benefit plan. But this consultant’s maximum tax-deductible contribution into a 412(i) plan could be as much as $332,357. Thus, if the consultant is in a 40% tax bracket, his income tax bill is lower, by over $130,000, due to the 412(i) plan.
Also, in this example, the 412(i) plan provides a contribution that is substantially higher than a traditional 401(k) profit sharing plan. See the chart below for other examples.
Maximum Contributions – Plan Comparison (2002 Limits) Age Retirement Age Traditional 401(k) Profit Sharing Traditional Defined Benefit 412(i) Plan 45 62 $40,000 $75,000 $145,236 50 62 $42,000 $128,166 $236,305 55 62 $42,000 $188,209 $332,357 60 65 $42,000 $194,847 $338,216
The 412(i) plan is very conservative. All asset accumulation rates and retirement benefits are fully guaranteed. This means these plans are safe from stock market fluctuations and are not influenced by economic down turns. They provide the added diversification that a traditional equity based portfolio needs to smooth out future investment performance.
The guaranteed rates in the insurance contracts that typically fund 412(i) plans are very competitive given today’s historically low interest rates. Current guaranteed rates will range from 4.5 to 5% and returns will average in the 6.25 to 7% range as interest rates begin to rise in the next few years.
The critical benefit in a 412(i) plan is how much income an individual can shelter from taxes. It’s the tax leverage that makes these plans superior to other types of plans. Another added benefit is that the life insurance policies than can be purchased in the plan are paid for with pre-tax contributions free death benefits to the beneficiaries on the pure death benefit above cash value. Still another advantage: A waiver of premium disability rider can be incorporated into the life policy, purchased with the plan to make this a self-completing plan if a disability occurs. How many qualified plans have that option?