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The retirement alternative: Sec. 412(i) plans.

Precipitous stock market declines have resulted in substantial losses for many retirement plans. Due to these losses and an uncertain future market direction, clients have had to rethink their investment strategies. Life insurance companies have seized this opportunity to promote a strategy, which mitigates the unfavorable effect of market declines, by touting Sec. 412(i) plans as a way of protecting retirement funds against future market fluctuations and economic downturns, while also providing substantially larger deductible contributions than traditional retirement plans.

As Sec. 412(i) plan marketers are likely to contact clients, tax advisers would be wise to become familiar with these plans. This item discusses how these plans work, who they benefit, and their advantages, disadvantages and potential abuses.

What Are Sec. 412(i) Plans?

Sec. 412(i) plans are defined benefit pension plans guaranteed exclusively with annuity contracts and life insurance. Such plans have been around since 1974, but were unpopular because the stock market offered larger potential returns. However, due to recent significant retirement plan losses, Sec. 412(i) plans are becoming fashionable. In uncertain markets, their guaranteed returns are enticing.

How Do They Work?

An employer funds the plan by making annual deductible contributions on behalf of eligible employees. The contributions are not taxable to the employees. The plan then purchases annuity contracts that provide a guaranteed return, typically ranging from 3%-5%. When an employee retires, the annuity will pay an annual retirement benefit, which will be taxable income to the employee.

The employer can make additional deductible contributions to the plan to purchase life insurance on employees' lives. This death benefit would be paid to the employees' designated beneficiary. The additional contributions are taxable to the employees to the extent of the "economic benefit"; see IRS Table 2001. The plan can only purchase an "incidental" amount of life insurance, typically limited to no more than 100 times the plan's monthly retirement benefit.

Advantages and Disadvantages

Even though Sec. 412(i) plans have a guaranteed positive rate of return on investment that shifts the risk from the employer/employee to an insurance company, the guaranteed returns are relatively low. However, in a time of uncertainty, a low guaranteed return may be a worthwhile tradeoff. Essentially, this eliminates the risk of even lower returns (and possible loss of principal) in exchange for a guaranteed rate of return.

Employers can substantially enhance the size of their tax deduction when contributing to a Sec. 412(i) plan, which is a significant benefit. However, they should compare Sec. 412(i) plans to traditional ones (funded by pension trusts), to select the most appropriate option.

Example: Business R wants to contribute to a retirement plan for a 50-year-old owner who will retire at age 60. The plan will yield a $1 million retirement benefit. If R uses a traditional profit-sharing plan, it can only deduct up to $40,000 of the annual contribution. However, under a Sec. 412(i) plan with a 4% guaranteed rate, it can make annual deductible contributions of $80,000. If the plan provides a death benefit, the annual deductible contribution will increase, exceeding $100,000.

Another advantage of Sec. 412(i) plans is the cost savings employers receive due to the administrative ease of calculating annual contribution amounts. Contributions are calculated using a simple present-value formula based on the guaranteed rate of return, the retirement benefit and the number of years until retirement. This eliminates actuarial expenses to calculate yearly contributions; such expense is a major disadvantage of defined benefit plans.

Who Benefits?

Owners of high-earning, stable businesses who want to contribute substantial deductible amounts to their retirement plans will most likely benefit from Sec. 412(i) plans. To achieve the maximum tax benefits, business owners should usually be in their 50s or older. Because the normal nondiscrimination, participation and vesting rules apply, businesses with fewer than 10 employees benefit most. (As the number of employees increases, the total cost of contributions rises and the business owner's retirement goals are potentially hindered.) Benefits also accrue to older individuals who have neglected to plan for retirement and can quickly fund a plan through the substantial contribution allowance.

Potential Abuses

To identify plan abuses, the IRS is looking at the use of "springing cash values," which occurs when a plan makes large initial payments on its insurance contracts, then the plan is terminated and the contracts transferred to plan participants. The contracts have a much lower cash value when compared to standard policies, minimizing an employee's income tax consequences when the contracts are transferred. After the transfer, the cash value builds rapidly; the income tax on the cash-value increase is deferred until paid to the participants in the future.

Conclusion

The recent popularity of Sec. 412(i) plans is forcing many tax advisers to learn more about a provision they previously hardly ever considered. Sec. 412(i) plans may allow some clients to achieve their retirement goals, while significantly leveraging the deductibility of their contributions and reducing their investment risk. However, such plans are not for everyone and they can be abused. Thus, tax advisers should become familiar with these plans, to determine if they suit their clients' needs and to protect them from potential abuses.

FROM JOSHUA C. EBNER, CPA, MST, OAK BROOK, IL
COPYRIGHT 2003 American Institute of CPA's
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Article Details
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Author:O'Connell, Frank J., Jr.
Publication:The Tax Adviser
Date:Sep 1, 2003
Words:878
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