How to Jump Start a Lagging Retirement Plan

There is a little-known retirement plan that can boost the retirement savings and tax benefits of small business owners. For the right person, the plan can boost retirement and tax benefits well beyond those of traditional plans. Unfortunately, some advisors are abusing the law and putting their clients’ retirements at risk.

The retirement plan is known as a section 412(i) plan, after the tax code section that authorizes it. Another name is the fully insured retirement plan.

A 412(i) plan is a form of defined benefit pension plan, the type of plan that promises a fixed annual income after retirement. The 412(i) plans are guaranteed by annuities and life insurance. Three benefits of a 412(i) plan are high current tax benefits, safety of retirement savings, and a guaranteed retirement income.

Under a 412(i) plan, an employer creates a plan and makes annual deductible contributions for employees. The contributions are deductible by the employer and tax deferred to employees. The plan has to purchase annuities with a guaranteed return. At retirement, an employee receives the promised annual benefit and pays taxes on it.

The 412(i) plan allows for substantial tax deductions in many cases, because of the low return promised by the annuities. Often the return is only 3% to 5%, but the tax deductions for the contributions should be considered part of the business owner’s return. For example, a 50 year old who plans to retire at 62 might be able to contribute less than $130,000 to a standard defined benefit plan but almost $200,000 to a standard 412(i) plan.  Because of dividends paid on the annuities, the deductible contributions will decline a bit after the first year.

Since this is a defined benefit plan, fairly level annual contributions must be made. For this reason, a 412(i) plan is best for a business with steady, high cash flow owned by someone age 50 or older who has accumulated few assets for retirement. To maximize the benefits to the owner, the business should have few or no other employees. Otherwise, the owner will be obligated to make substantial contributions for the benefit of other employees.

To reduce the cash flow obligation, the plan can be created to promise less than the maximum allowable retirement benefit. As retirement nears, if the owner is confident of the cash flow, the promised benefit can be increased. That also will increase deductions.

A 412 (i) plan has several advantages over a regular defined benefit plan. The annual contribution calculation is simple, so the expense of an annual actuarial report is not required. The plan also does not have to deal with the full funding rules, which are complicated and can eliminate or decrease planned contributions. The employer also doesn’t have to make quarterly contributions. A potential disadvantage is that plan assets cannot be lent or pledged.

In return for the advantages and the safety of the plan, fairly low rates of return must be accepted. Over the last few years the 3% to 5% returns guaranteed by the annuities look pretty good compared to the stock market, and the annuities guarantee no losses. But in headier times the returns seemed disappointing.

An additional potential benefit of the program is that the employer also can make contributions that buy life insurance payable to the plan beneficiary. Up to 50% of the cost of the plan can be funded with life insurance. This increases deductions and allows the purchase of life insurance with tax deductible dollars. But it also allows for some games to be played and can lead to abuses. The abuses can cause trouble with the IRS.

Some advisors tout a strategy involving special insurance policies called springing or sponge life insurance. Under these policies, there is little cash value in the first five years or so despite high contributions. The theory is that the plan member then can purchase the policy from the plan for its current cash value, which is less than the contributions made. Then, under the terms of the policy the cash value greatly increases in the next year or two.

This cheats any other beneficiaries who belong to the plan and also likely violates rules against self-dealing and other prohibited transactions. Such actions jeopardize the plan’s tax status and could lead to penalties. The plan and employer are not protected by relying on a legal opinion letter provided by the advisor promoting the plan.

A 412(i) plan can be a good way to jump start a lagging retirement plan. Deductible contributions are increased, and the future income from the plan is secure. A self-employed person with reliable cash flow should consider the plan. But beware of the more aggressive schemes out there. The basic plan provides plenty of benefits without risking trouble with the IRS.