S—412(e)(3) Plans
A 412(e)(3) plan is a defined benefit plan that is funded by life insurance and annuities. to the Pension Protection Act of 2006, these plans were governed by IRC Section 412(i) and are, therefore, sometimes promoted as 412(i) plans. These plans provide high-earning business owners who have stable cash flow an opportunity to make maximum deductible retirement contributions while offering a high degree of security to plan participants.
PLAN REQUIREMENTS. 412(e)(3) plans are subject to all the requirements that apply to other defined benefit plans, including nondiscrimination, vesting and benefit limitations. (For example, the plan must generally include all full-time non-union employees, except for employees younger than 21 and those with less than one year of service.) In addition, they must generally meet the following six additional requirements: (1) the plan must be funded exclusively by life insurance policies and/or annuities guaranteed by a state licensed insurance company; (2) contracts must have level premiums; (3) benefits must be provided entirely by these contracts; (4) premiums must be paid without lapse; (5) contract rights cannot be subject to a security interest; and (6) no policy loans are allowed.
It is important to recognize that a defined benefit plan entails an obligation on the part of the employer to fund the plan each and every year. Failure to make regular premium payments could cause it to fail the IRS requirement that the plan be “permanent.”
FUNDING. Known as “fully insured” plans, 412(e)(3) plans are typically funded with a combination of life insurance and annuities. The primary purpose of the plan must be to provide retirement income. Therefore, when life insurance is used it must provide participants with no more than an “incidental” death benefit. To satisfy this requirement defined benefit plans often limit the insured death benefit to not more than 100 times the expected monthly benefit. This “incidental” death benefit requirement is also satisfied if: (1) the cost of the benefit is less than 25 percent of the cost of all benefits provided under the plan (the 25 percent rule); or (2) less than 50 percent of the employer contribution credited to each participant’s account is used to purchase “ordinary life insurance” (if either term insurance or universal life insurance is purchased the 50 percent is reduced to 25 percent).Excessive funding may result in nondeductible contributions and “listed transaction” status. Each plan participant has the right to name the beneficiary of this death benefit and must include in income an amount equal to the “economic benefit” of the life insurance benefit.
THE TRADEOFFS. Because 412(e)(3) plans are exempt from the full funding limit that otherwise applies to defined benefit plans, they offer (within limits) the opportunity to make accelerated contributions resulting in large upfront tax deductions. Simplicity is achieved with conservative low-risk life insurance and annuity contracts that shift investment risks from the employer to the insurance company. The IRS has scrutinized these plans in recent years because of questionable actuarial assumptions being used to increase the level of funding. These plans offer pre-retirement death benefits that are easy to calculate and plan benefits that are easier to understand. If there are excess earnings they must be used to reduce future contributions that fund plan benefits. 412(i) plans
also avoid both excise and income taxes on reversions to the employer, since they are fully funded by the annuity values and life insurance cash vales that determine the retirement benefit.
In contrast, other defined benefit plans provide more flexibility in both plan design and investment options. This offers the potential for high investment returns, but this entails fewer guarantees and increased risk (i.e., risk and return go hand in hand). Initial costs tend to be lower, but ongoing administrative and actuarial costs tend to be higher in comparison to 412(e)(3) plans.
When compared to other funding vehicles, such as variable annuities or equity investments, the question of whether the large and accelerated tax deductions produced by 412(e)(3) plans adequately compensate for their comparatively low guaranteed rates of return is controversial. Ultimately the decision may be more influenced by a desire to: (1) fund life insurance on a tax deductible basis; and (2) avoid the risks associated with equity investments.