Section 412(i) Defined Benefit Plans: Simplicity, Safety, and Power
In the months since the Enron debacle1 came to light, many people have questioned the potential dangers of 401(k) and other forms of defined contribution plans and the merits of a guaranteed retirement income stream found in defined benefit (DB) pension plans. Although lacking the “sexiness” of the potential stock market home run, DB plans remove the gamble in favor of a retirement income stream for life. DB plan benefits are legally enforceable under ERISA. Benefits are even guaranteed up to about $42,000 annually by the Pension Benefit Guaranty Corporation (PBGC). Since 1971, there has been an astounding reduction in the numbers of DB plans, with expense of operation and complexity being the commonly given reasons.
In the last several years, planners have rediscovered the utility of DB plans, especially §412(i). Section 412(i) of the Internal Revenue Code (“Code”) provides an exemption from certain funding requirements if a qualified plan satisfies the requirements of that subsection. Those requirements and other issues involving 412(i) plans are discussed in the following questions, answers, and tables. Lawyers and their clients should know their options in this environment of fewer and fewer income tax advantages.
Q: What is a 412(i) plan?
A 412(i) plan is a defined benefit plan whose funding (annual contribution) is calculated under the rules of Code §412(i). It is also referred to as a fully insured plan. Perhaps the least technical way to describe a 412(i) is private social security, guaranteed by both the government and an insurance company.
Q: Why should an employer seek to qualify a plan under §412(i)?
If a plan qualifies under Code §412(i), it is exempt from the other funding requirements of Code §412, including: a) the minimum funding standard account; b) the full funding limitation; c) quarterly contributions; d) actuarial assumptions imposed by the IRS; and e) the Schedule B enrolled actuary’s certification otherwise required with the Form 5500 for the plan.
Q: What is the difference between a 412(i) plan and any other defined benefit plan, and how does the difference affect contributions?
Only the funding assumptions are different. A 412(i) plan must meet all requirements of the Code relating to eligibility, participation, coverage, distributions, maximum benefit, and so on. In a traditional defined benefit plan, an enrolled actuary certifies reasonable actuarial interest assumptions and completes a Schedule B for filing with Form 5500. Under a 412(i) plan an enrolled actuary is not necessary, because the plan’s assumptions are based on the guarantees of the insurance contracts. Typically, the contract guarantees are much lower than the interest assumptions used under a traditional defined benefit plan. This results in higher contributions (deductions) under a 412(i) plan as compared to all other retirement plans.
Just like traditional pension plans, an employer may exceed the $41,000 contribution limitations of defined contribution plans. Table 1 below illustrates the large deduction possibilities for an employer who desires a pension payment of $165,000 per year:
Q: What requirements must the plan meet to qualify under Code §412(i)?
Generally, the requirements for qualification of a plan as a 412(i) plan are as follows:
1) The plan must be funded exclusively with insurance contracts, defined by the regulations as annuity contracts or a combination of insurance policies and annuity contracts;
2) The contracts must provide for level annual premium payments to begin when the individual becomes a plan participant and extending not later than the retirement date under the plan;
3) The plan’s benefits at normal retirement age must be guaranteed by the insurance carrier who issues the contracts to the extent premiums have been paid;
4) Premiums payable for the plan year and all prior plan years under such contracts must have been paid;
5) No rights under the contracts may be subject to a security interest during the plan year; and
6) No policy loans may be outstanding at any time during the plan year.
Q: In addition to annuities, can life insurance be used as a plan funding vehicle?
Yes. In fact, very large amounts are possible in some situations where there is a need for death benefit protection. In certain situations, joint life policies may be used.
Q: Can a self-employed individual or partnership establish a 412(i) plan?
Yes. Individuals and small entities must, however, be careful if they have income that fluctuates significantly from year to year. The plan is not generally suitable for self-employed individuals unless the individual has experienced stable past earnings and expects future earnings to be similarly sufficient to fund the plan in the future. On the other hand, a sole proprietor or sole shareholder with no employees cannot find a more efficient retirement and financial planning arrangement. Tax deductible life insurance is always better than paying premiums with after-tax money. Proprietors and small businesspersons (including lawyers) are in most need for a stable retirement arrangement. Table 2 below illustrates one scenario with a benefit equal to 100 percent of salary.
Q: Can any insurance company handle a plan intended to qualify under §412(i)?
It was previously promoted among certain companies that an insurance carrier whose products are designed to meet the requirements of Code §412(i) must be used for funding a 412(i) plan. That conclusion is not supported by the statute or regulations. Reg. §1.412(i)-1(b)(ii) provides that contracts which do not initially qualify may be modified by an extra-contractual agreement between the plan and the insurance company. Most insurance companies, however, cannot do this nor illustrate advanced techniques like cross-testing. Such design usually requires the assistance of a specialist.
Q: Can variable insurance and annuity products be used to fund a 412 (i) plan?
Yes. A business process has been invented whereby guarantees can be affixed to variable insurance or annuity arrangements so as to make them eligible for use in 412(i) plans. A patent for the process, called VARIABLE 412(i) ™, is expected to issue this year retroactive to 2001.
No provision of the Internal Revenue Code, regulations, or any published ruling prohibits the use of any particular insurance product in a qualified plan. Any such attempt would be legally unenforceable. Remarkably, IRS classified variable insurance as whole life insurance in Private Letter Ruling 9014068 (January 11, 1990), reasoning that so long as the policy could be illustrated and operated with a level death benefit, it bore more resemblance to permanent insurance than to term insurance even if its cash surrender value was ultimately determined by market performance. [Variable insurance looks a lot like the old retirement income contracts to which the IRS never objected.] The insurance community has been slow to adopt this new approach, in part, because of refusal to pay royalties, gimmicks described below, and the greater profitability of standard whole-life contracts they are using to fund 412(i) plans.
Q: If there is no insurance need, should a 412(i) plan be funded with insurance?
An unbiased lawyer would often say, “No.” The National Underwriter recently reported on the cash-on-cash rates of return for 15 major carriers who sell traditional whole-life policies. During a 10-year period ending in 2003, cash-on-cash returns were very disappointing, to say the least. Over 20 years, such insurance accumulates cash at an average rate of return of 4.4 percent. Consequently, clients in the 10- to 15-year funding category should have a discernible insurance need, or the ability to increase overall investment performance of policies, or a large disdain for taxes. Otherwise, it would appear most wise to use an annuity-only design. [ VARIABLE 412(i) ™ makes such concerns irrelevant because the ultimate rate of return over 10 years for variable contracts has historically been higher, even with recessions.]
The more appropriate question, however, is whether there is ever not an insurance need. After all, if the client dies with money in a retirement plan, it will be subject to income and estate taxation of 70 percent to 80 percent depending on the decedent’s state of residence. If for no other reason, life insurance of some type should be considered to prevent severe erosion of the plan’s payment at death to the participant’s beneficiaries. The life insurance to protect benefits would be, after all, tax deductible.
Q: What funding assumptions are used under a 412(i) plan?
Since the plan benefits must be guaranteed at normal retirement age by annuity contracts with or without insurance policies, the plan assumptions must be based on the guaranteed values in the contracts. This means the plan must fund for benefits based on the guaranteed annuity conversion factors in the contracts and must assume the pre-retirement interest assumption guaranteed in the annuity contract.
The guaranteed annuity conversion factor will be up to 40 percent higher than normal post-retirement assumptions, and the guaranteed interest accumulation rate in the contract might be half the normal preretirement interest assumption ( e.g., two percent to three percent). Stated another way, an annuity of $165,000 per year may be projected to cost $2.4 million at normal retirement age, and this amount is the target for the plan. If, however, the actual conversion rate on the date of retirement requires less money [because the insurance company has a cheaper annuity than the one guaranteed], the plan will experience a gain. This combination of guaranteed assumptions usually creates higher deductible contributions for the plan, and future excess money for other uses, like post-retirement medical benefits under §414(h).
In contrast, a typical defined benefit plan will be shooting for a maximum accumulation of $1.7 million [known as the GATT limit] to render a $165,000 per year retirement benefit. The lowest permitted actuarial assumption is approximately five percent, and it most likely will increase as interest rates rise. This will decrease allowable deductible contributions. As the reader can see, the client and the plan are at the mercy of the economy and IRS in a typical defined benefit plan.
Q: Will the plan benefit be greater if the annuity is currently paying interest in excess of the guaranteed rate?
Yes, if the plan benefit has not been calculated on the basis of the maximum benefit. The plan is credited with the full current rate of interest. Any interest in excess of the guaranteed rate is used to reduce the next year’s plan contribution. However, as discussed above, if there is a more favorable annuity purchase rate than the one assumed for the plan, the plan’s actual benefit will be greater. Therefore, one might fund for a benefit of $120,000 per year and find that a better annuity purchase rate yields $165,000 per year from the fund. The IRS has ruled this does not violate the “definitely determinable benefit” rule.
Q: Can a participant in a 412(i) plan borrow under the plan?
No. Loans are not allowed under the 412(i) plan rules.
Q: Can an existing defined benefit plan become a 412(i) plan?
Yes. It is possible, in many situations, to convert a defined benefit plan to one that qualifies under 412(i) funding rules. Section 412(i) treatment can often ameliorate the problems of overfunding in other plans.
Q: Must the plan cover employees, other than owners?
In most cases, yes. If employees are eligible under the regular retirement plan rules, they must be covered in a 412(i) plan. Section 401(a)(26) mandates that a defined benefit plan, 412(i) or not, cover the lesser 50 employees or 40 percent of eligible employees. If there are 10 employees, at least four have to be in the defined benefit plan. Another test requires that the participation of non-highly-compensated employees (“NHCE”) be at least 70 percent of the participation percentage of highly compensated employees. If 60 percent of HCEs benefit, then at least 42 percent of NHCEs must benefit.
This latter rule creates opportunities if there is great disparity in ages among owners. Assume we have two owners, one age 55 and the other age 45. They employ 10 other people. If the younger HCE waives participation, the minimum coverage of the others is 35 percent [50% x 70] or four persons. Such persons can, in most small companies, be reasonably classified to distinguish them from another class of employees. Covering five employees satisfies the §401(a)(26) requirement of 40 percent participation.
Q: How does the Retirement Protection Act (RPA) of 1994 (a provision within the GATT legislation) affect 412(i) defined benefit plans?
RPA ’94 affects the maximum lump sum that may be paid from a defined benefit plan (including a 412(i) plan) at retirement or termination of employment. GATT limits the maximum lump sum payable by GATT-specified interest rate and mortality.
In most cases, this will reduce the maximum lump sum amount that can be paid from the defined benefit plan. To avoid accumulating excess assets, the benefits to be funded should be reduced. Although this decreases the deduction compared to pre-GATT provisions, the deduction is still significantly higher in 412(i) plans than could be generated in any other qualified plan type. This provision affects only those benefits at or close to the Section 415 dollar limit (currently $165,000 annually) and only if taken as a lump sum.
Q: Should a defined benefit plan consider terminating if the plan has reached the full funding limit as a result of current assets being well in excess of the present value of benefits?
If excess assets revert to the employer upon termination, the plan could face tax penalties of as much as 50 percent of those excess assets. In addition, the reversion of assets is taxable to the employer. 26 USC §4980. On the other hand, if excess assets are transferred to a “qualified replacement plan,” the first 25 percent is not subject to excise tax, and the remainder is subject to a reduced tax of 20 percent. A portion of excess assets may be transferred to a §401(h) account for post-retirement medical benefits.
Before terminating, a plan should explore the possibility of converting to a 412(i) plan, since this conversion may eliminate the excess asset situation and may even restore the availability of deductible contributions for the plan. To avoid possible loss of tax deduction, it is advised that the plan stay in existence for at least three years beyond the conversion. The GATT limitation compels an advisor to stay abreast of plan balances and to accordingly adjust funding strategies.
Q: Can 412(i) design help an over-funded standard defined benefit plan?
Some plans may be too overfunded for a 412(i) plan to be a solution to their problems. Since the appeal of the 412(i) plan will depend upon the amount of assets in the plan in relation to the current accrued benefits, each circumstance would need to be analyzed to explore whether 412(i) plan design is viable.
The requirement that all assets of a 412(i) plan be with an insurance company may not be appealing to some employers. The absence of a loan provision in a 412(i) plan may be another factor weighing against adoption of this type of plan, although loans are generally limited only to the lesser of $50,000 or one-half an accrued benefit. However, shifting investment risk to an insurance company would tend to reduce the risk of fiduciary liability under ERISA.
Q: Is a 412(i) plan less appealing to a larger firm?
Sometimes. design, a 412(i) plan generates a large contribution for plan participants. The concept may become less appealing as the number of plan participants increases because of insurance expense. The classic 412(i) prospect typically had eight or fewer employees in the plan. However, these design limitations can be overcome using VARIABLE 412(i)™, by using annuities more prevalently than life insurance, or by using cross-testing or floor-offset arrangements to reduce the amount of contributions for lower-compensated employees.
Q: What is cross-testing?
Cross-testing is a method of determining nondiscrimination by reference to an assumed contribution and growth of a defined contribution account, and then comparing a projected annuity benefit generated by the assumed growth against the benefit promised to other employees by a 412(i) plan. Cross-testing can be a relatively complex calculation, as described in Treasury Regulations under §401(a)(4). In the alternative, an employer desiring a most efficient 412(i) plan can make a “gateway” contribution of seven and a half percent of compensation for employees who participate in a defined contribution plan. The benefits of using cross-testing can be dramatic. For example in some situations, the share allocated to highly compensated employees can increase from 70 percent to over 90 percent.
Q: Can a 412(i) plan be funded entirely with a life insurance contract?
Not the way some insurance companies have been promoting it. This was a problem IRS characterized as an “abuse,” and has now been addressed by Proposed Regulations (REG-126967-03), two Revenue Rulings, (Rev. Rul. 2004-20, 2004-10 IRB 546 and Rev. Rul. 2004-21, 2004-10 IRB 544), and a Revenue Procedure (Rev. Proc. 2004-16, 2004-10 IRB 559) issued on February 13, 2004.2
Years ago, many insurers offered retirement income contracts that could be used to satisfy 412(i) funding requirements.3 These contracts guaranteed both premiums and cash values that would be sufficient to accumulate to the guaranteed amount needed to convert to the guaranteed income benefit. These retirement income contracts promised face amounts of 100 times the monthly pension benefit, and both high guaranteed premiums and high guaranteed cash values that would equal all cash value within the five to seven years prior to normal retirement age. In essence, these contracts looked like annuities with term insurance attached. Old Revenue Rulings from the IRS appear to have approved funding exclusively with such contracts. At no time has the IRS approved 100 percent funding with traditional permanent insurance, since insurance is an “incidental benefit.” The incidental benefit rule has never been interpreted to allow more than 50 percent funding for whole-life insurance. Rev. Rul. 74-307, 1974-2 C.B. 126. For over 30 years, the IRS opined that a plan funded only with life insurance policies is not a retirement plan and will be disqualified. Rev. Rul. 81-162, 1981-1 CB 169; Rev. Rul. 54-67, 1954-1 C.B. 149.
In recent years, some insurance salespersons [turned pension consultants] distorted the old rulings on retirement income contracts to the point of absurdity. They recommended using “specially designed” very high-premium, very-very low-cash value life insurance contracts that required extraordinarily high face amounts to accumulate to the guaranteed values needed. These contracts were sold with the promise of extraction at the artificially depressed cash values, resulting in an alleged current deduction and virtually no tax upon extraction. The concept never worked from a purely analytical tax perspective. Nobody in his right mind would spend a million dollars on a policy and then sell it for 20 percent of its value, knowing that value would mysteriously “spring” into it after it came out of the plan. The new proposed regulations confirm that the extraction value must be something closer to actual accumulated premiums less reasonable mortality charges.4
These new distorted contracts, in all cases except owner-only plans,5 also implicate ERISA issues dealing with suitability, fiduciary duty, and best interest of plan participants. In addition, contributions for insurance face amounts in excess of the incidental benefit amounts are not currently deductible.6 The new guidance restates this rule. Many people are going to be shocked to find up to 80 percent of their “contributions” held not deductible and possible disqualification of their plans.
Q: Can I adopt a 412(i) plan if I have a profit-sharing or 401(k) plan?
Yes. After December 31, 1999, the “dual plan limitation”7 no longer applies. Thus, someone who previously contributed to a profit-sharing plan can opt out of that plan in favor of accumulation of more money in a 412(i) arrangement. This is a great way to substantially increase assets for retirement. Contributions to a 412(i) plan when one is older can result in an additional $1.7 million of retirement money on top of an existing plan balance.
Q: Can a 412(i) plan function as an asset protection vehicle?
Yes, especially if the plan covers employees or other favorable state law applies. The Supreme Court has made clear on several occasions that ERISA-qualified plans are exempt from creditor claims in bankruptcy. Patterson v. Shumate, 504 U.S. 753 (1992). The term ERISA-qualified plan was first thought to mean a plan that is subject to ERISA and is qualified under §401(a) of the Internal Revenue Code. Both ERISA §206(d)(1) and IRC §401(a)(13) require that a pension plan must provide that benefits under the plan may not be assigned or alienated. The Seventh and Fifth Circuits, in the cases In re Baker, 768 F.2d 191 (7th Cir. 1985), and In re Sewell, 180 F.3d 707 (5th Cir. 1999), however, have read “ERISA-qualified” a little differently than first thought. The Seventh Circuit in Baker found that a pension plan is not required to be tax-qualified under the IRC in order to be ERISA-qualified. The Fifth Circuit, in Sewell, agreed finding that whether a plan was tax-qualified was irrelevant in determining whether pension assets were protected from the bankruptcy estate. The key for these courts was an enforceable anti-alienation provision.
Section 403(b) annuity plans, most often seen in the nonprofit context and comprised of individual annuities, have been held not protected unless plan assets are held in trust. In re Adams, 302 B.R. 535 (6th Cir. BAP 2003). IRA and SIMPLE plan assets are, by definition, not held in trust and numerous cases hold they are not protected under federal law because they are not covered by ERISA.8
Since exemption from the bankruptcy estate under 11 USC §542 applies to assets exempt under “non-applicable bankruptcy law,” state law exemption statutes or spendthrift trust laws can and often do provide a haven for those retirement assets not covered by ERISA. For example, the 11th Circuit found that if an IRA is protected from garnishment under state law, then it is exempt from the bankruptcy estate. In re Meehan, 102 F.3d 1209 (11th Cir. 1997) (applying “important congressional policy of protecting pension benefits” articulated in Patterson v. Shumate ).
Numerous states, like Florida,9 have enacted laws specifically protecting IRAs and nonqualified pension plans. For the 412(i) plan, Florida may provide another haven for owner-employees not found in other states. Since the plan is funded by life insurance and annuity contracts, it would also appear that even if the plan is not “ERISA qualified,” the contents would be exempt under F.S.A. §222.14, which protects “the cash surrender value of life insurance policies and annuity contracts from legal process.” In re Wilbur, 206 B.R. 1002 (Bankr. M.D. Fla. 1997). In light of the foregoing, a 412(i) plan makes an excellent addition to an asset protection strategy without going to the trouble of setting up offshore trusts.
For those who plan estates as a primary or secondary practice area, the need for cash in the “golden years” should be obvious, and clients should be encouraged to take advantage of retirement plans. Section 412(i) plans help to satisfy current and future cash needs by accelerating contributions, taking advantage of favorable tax rules, and providing income when it is most needed. Guaranteed cash at retirement is not such a bad thing, especially when it can be free of creditors’ claims.
1 The ERISA issues involving Enron are chronicled in the amicus curiae brief filed by the U.S. Department of Labor (DOL) in Tittle v. Enron Corp., No. H-01-3913 (S.D. Tex.), and available electronically at www.dol.gov/sol/images/EnronBrief1.fnl.PDF. Tittle v. Enron was a class action filed on behalf of an estimated 24,000 current and former Enron employees. The case was settled in 2004.
2 A substantial portion of this new guidance can be traced to an article published approximately 13 months previously. Koresko, Section 412(i) Plans: Emerging Abuses Involving Depressed Cash Value Life Insurance, J. Pension Benefits (Winter 2003). Another more recent article also explains the new IRS pronouncements: Simmons and Leimberg, Prop. Regs. Address Abusive Transactions Involving Life Insurance In Qualified Plans, 31 Est. Plan. 163 (Apr. 2004) (citing Koresko article).
3 See, e.g., Rev. Rul. 73-56, 1973-1 C.B. 196; Rev. Rul. 68-304, 1968-1 C.B. 179; Rev. Rul. 68-31, 1968-1 C.B. 151.
4 The Regulations will apply to distributions from retirement plans governed by §402(a), which generally provides that distributions from a trust described in both §§401(a) and 501(a) is taxable under §72 in the year of distribution. The Regulations will also govern transactions from “group term insurance plans” described in section 79 and non-plan distributions from an employer under §83.
5 See Leckey v. Stefano, 263 F.3d 267 (3d Cir. 2001) (plan with only owners and immediate family members not covered by ERISA); Cf. Raymond B. Yates M.D., P.C. Profit Sharing Plan v Hendon, 541 US ___, 158 L. Ed. 2d 40, 124 S. Ct. 1330 (2004) (ERISA protection rights for retirement plans with common law employees and owner-employees).
6 Rev. Rul. 55-748, 1955-2 C.B. 234 first stated this rule, and it finds confirmation in the new guidance.
7 Section 415(e) was repealed, effective for years beginning on or after January 1, 2000, by the Small Business Job Protection Act of 1996. See also Notice 99-44, 1999–35 IRB 326.
8 See, e.g., In re Weinhoeft, 275 F.3d 604 (7th Cir. 2001).
9 I.R.A. and Keogh accounts are exempt pursuant to Fla. Stat. §222.201; see In re Suarez, 127 B.R. 73 (Bankr. S.D. Fla. 1991).
John J. Koresko V is a member of Koresko & Associates, A Professional Corporation, Bridgeport, Pennsylvania, where his primary practice areas are taxation, estate planning, and ERISA. He received his B.S., magna cum laude, in accounting from Clemson University (1979) and his J.D. from the University of Miami School of Law (1983).
This column is submitted on behalf of the Tax Section, William D. Townsend, chair, and Michael D. Miller, Benjamin A. Jablow, and Normarie Segurola, editors.