Get maximum tax deduction with a 412(i) pension plan

The right qualified retirement plan can enable even older business owners with very few years to retirement to accumulate substantial retirement assets. Selecting the proper plan design to meet these older business owners’ goals can make a significant difference in their financial security.

Fortunately, a number of qualified retirement plans specifically favor those aged 40 to 70. Defined benefit plans can provide exceptionally high contributions for the older employees.

The benefit formula in a defined benefit plan defines the monthly benefit each participant will be entitled to receive at retirement. The monthly benefit is usually based on the participant’s compensation and years of service or participation. At retirement the participants will receive this monthly benefit.

Although defined benefit plans are subject to maximum benefit limitations, there is no dollar limit on the amount of contributions to a defined benefit plan: the annual contribution is actuarially-determined as the amount necessary to provide the promised benefits at retirement.

CONTRASTED WITH DEFINED CONTRIBUTION PLANS

A defined contribution plan defines the contribution each participant will receive each year. These contributions may be a percentage of the participant’s compensation. The employer’s contribution is allocated to the accounts of the participants, and these accounts are adjusted for earnings or losses and forfeitures each year. At retirement the participants receive their account balances with all the contributions (and forfeitures) made to the account plus or minus the earnings or losses.

The maximum contribution (including forfeitures) that can be made for any participant in a defined contribution plan in 2003 is just $41,000 (or $42,000 if the participant is age 50 or older and makes a $2,000 catch-up deferral). Therefore, the contribution for an individual in a defined benefit plan can be as high as necessary to fund the individual’s benefit at retirement using reasonable actuarial assumptions and methods.

The ideal sponsors for defined benefit plans are businesses that have older business owners or key employees (above age 45) who wish to fund more than $40,000 toward the owner/key employee’s contributions. The business should have the ability to make continuing plan contributions. While future plan contributions can be reduced by amending the benefit formula defined benefit plans are subject to minimum funding standards that make flexibility in contributions more difficult than under defined contribution plans.

TRADITIONAL DEFINED BENEFIT PLANS VS. FULLY INSURED 412(i) PLANS

Defined benefit plans may be either:

• Traditional Defined Benefit Plans or
• Code Section 412(i) Plans.

Traditional defined benefit plans are funded through investments purchased by the trustee in accordance with the ERISA investment restrictions. The trustee is responsible for prohibited-transaction rules, etc.

The 412(i) or fully insured plan is a special type of defined benefit plan that must satisfy the requirements of IRC 412(i) and Treas. Reg. § 1.412(i)-1. 412(i) plans are funded policies and annuities. In addition to the cost of the ancillary life insurance benefit, 412(i) plans add provide

greater maximum contributions than traditional defined benefit plans because the funding is based on the rates guaranteed under the insurance and annuity contracts (frequently less than 5%) rather than “reasonable actuarial assumptions”. In addition, 412(i) plans are exempt from the current liability full funding limitation imposed under Code Section 412(c)(7).

412(i) plans permit the highest possible contributions and tax deductions for older business owners, particularly in the plan’s early years. As with other defined benefit plans, older employees receive higher contributions to fund the benefits than under a defined contribution plan. Such contributions in some cases can exceed 100% of current salary.

Since the plan’s benefits are entirely funded through life insurance and/or annuity contracts, business owners sponsoring 412(i) plan enjoy a higher degree of security than sponsors of other qualified plans. The trustee is relieved of the investment responsibility and ERISA investment concerns. An insurance company guarantees the benefits with the insurance grow at a guaranteed rate and are not influenced by market fluctuations or economic downturns.

Additionally, life insurance can be included in these plans to ensure that the participants’ beneficiaries are provided for in case of the death of the participant. If a disability waiver is added to the policies, then the death benefit protection and cash value growth can be guaranteed even if the participant becomes disabled and cannot continue working.

A plan that fulfills these requirements is exempt from certain requirements that can reduce the contributions of other defined benefit plans. Traditional defined benefit plans, for instance, are subject to the current liability full funding limitation. This limitation reduces contributions in a traditional defined benefit plan during the plan’s early years, in some cases below what is needed to adequately fund the plan. Many businesses prefer to contribute higher amounts they have profits rather than push a portion of the costs into the future.

Since funding for 412(i) plans is based on contractual guarantees, 412(i) plans are not required to file the Schedule B (Actuarial Report) form that is attached to form 5500 for a traditional defined benefit plan. This can result in a real savings in actuarial and administrative costs for the 412(i)plan over a traditional defined benefit plan.

412(i) vs. Traditional Defined Benefit Plan – 2002 Retirement Age 62 Comp. $200,000

In the example we compare a 412(i) plan to a traditional defined plan and a defined contribution plan. All three plans have three participants, ages 45, 50 and 55, and we have assumed that all are owners.

Each of the owners has a salary of $200,000 and is funding for the highest benefits allowed in a defined benefit or defined benefit plan in 2003. The 45 year old and the 50 year old have projected benefits of $160,000 per year ($13,333 per month) while the 55 year old’s projected benefit has been reduced for less than ten years of participation ($13,333 X 7/10 = $9,333).

In all cases their contributions in the 412(i) plan are higher than they would have been in a traditional defined benefit plan and much higher than the $40,000-$42,000 that would be allowed in a defined contribution plan. The 55 year old, even with the benefit reduction, still has a contribution of $332,357 in the 412(i) plan, which is significantly higher than the $178,060 contribution to the traditional defined benefit plan.

Because no investment funds are allowed, the 412(i) plan cannot accept rollover accounts from any other plan and will probably not be allowed to provide the new individual IRA accounts allowed in 2002 under Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).

Early termination may increase the business owners’ benefits because they can roll their benefits from the terminated 412(i) plan into a new profit sharing plan. At their normal retirement dates they will have not only have the amounts rolled over from the 412(i) plans and gains or losses on those rollover amounts, but they will also have their contributions to the profit sharing plans plus any gains or losses on these profit sharing contributions. A 412(i) plan allows a business owner to make the largest contribution to a retirement plan.

Buyer Beware

Regrettably, as 412(i) plan popularity has soared, some planners and consulting firms are sacrificing the assuredness of the tax deduction by introducing untested and potentially risky interpretations of IRC 412(i) and how these plans can be funded. This troubling development was a principal topic of conversation at last May’s National Pension Directors meeting as several prominent insurance companies discussed and debated: just what is a 412(i) plan?

Abusive Tax Shelter?

Officials from the IRS have publicly and privately expressed concerns about abuses in the 412(i) arena. At one recent forum, the 2003 Los Angeles Benefits Conference, concerns were expressed primarily about two perceived abuses:

1. Utilization of life insurance contracts rather thanannuities as the funding vehicle or primary funding vehiclefor 412(i) plans;
2. Use of life insurance products designed to minimize cash values upon early plan termination, and
3. Funding for benefits that that exceed Code Section 415(b) limitations.

While IRS has several sources of attack on abusive plans, they have recently shown a penchant for labeling such abuses as “potentially abusive tax shelters”.

In a recent case IRS aggressively attacked such a potentially abusive tax shelter that was being used to provide employee welfare benefits (not retirement benefits). In the case of Neonatology Associates, P.A et at vs. Commissioner of IRS, US Tax Court, Docket Nos. 1201-97, 1208-97, 2795-97, 2981-97, 2985-97, 2994-97, 2995-97, 4572-97 (July 2000), the Tax Court showed its ability to deconstruct a case using a Step Transaction Theory to ascertain if the tax benefits of a purported tax shelter are valid.

In this decision, a 419A(f)(6) tax shelter that used “speciously-designed” life insurance contracts inside a “deviously-designed” benefit program was held to be a dividend to the owner of the corporation in a “thinly veiled scheme” to defraud the government of tax revenues, and to enrich the life insurance agents who created and marketed it. Ouch!!

We recently heard a 412(i) plan described as “two retirement plans in one: one for the participant and one for the insurance agent.” However, such a criticism applies to the abusive plans described above. We believe that 412(i) plans are viable when avoiding the pitfalls described above: a properly structured 412(i) plan eliminates risk while assuring a maximum tax deduction and retirement benefit.

The information provided herein is not intended as legal, accounting, financial or any other type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.

For more information please contact Mike Sheth at 281-772-4141 or 832-685-7219
or email at sigmaplan@yahoo.com.

About Mike Sheth

Mike Sheth, President of Sigma Senior Resources, started his career as an engineer with major companies like Rolls Royce and General Motors Corporation. He then moved into the financial services arena becoming a financial advisor and has been assisting professionals and senior retirees for the last 25 years. He began his career with the Prudential Insurance Co. of America as a financial advisor, and became a manager for the company. In 1992 he formed one of the largest PPO network in America known as Xonex Healthcare Group. Mr. Sheth is the founder of Sigma Senior Resources, a comprehensive financial services firm specializing in assisting professionals and seniors.

Mr. Sheth is a Certified Estate Planning Counsel, Certified IRA distribution Advisor and a Certified Annuity Advisor. He is also a certified Third Party administrator and a broker agent appointed by the State Board of Insurance of Texas.

Mr. Sheth has presented several papers on estate planning at various medical facilities and community organizations. He has written several articles concerning Long Term Care and the myths surrounding Certificates of Deposits. He has also authored a book titles Estate Planning Strategies for the 1990’s, which is currently in the process of being updated.

Some of the major services provided by Sigma Senior Resources are insurance and annuity advice and selection, Long Term Care advice and selection, Medicare planning, reduction of Taxes relating to retirement plan distribution, estate planning, and conservator ship and trustee services. The firm also trains other financial professionals in the technical aspects of financial advising and marketing of their practices.

Mukul (Mike) Sheth CAC, CEPC, CIDA
Sigma Senior Resources

18723 Martinique Drive
Houston, Texas, 77058
Phone: 832-685-7219
Email: sigmaplan@yahoo.com