During volatile markets, opening your 401(k) statement can be disheartening. Business owners and
professionals may find an appealing option in a 412(i) plan, a defined benefit pension plan funded by life
insurance and/or fixed annuities, based on the owner or executive’s need and insurability. In exchange
for a typically lower rate of return than a 401(k) plan, participants in a 412i plan can make larger annual
contributions, receive a guaranteed retirement benefit and reduce their taxable income. Because they
use insurance products, 412(i) plans are exempt from minimum funding requirements that apply to
traditional pension plans.

412(i) plans generally work best for businesses with 10 or fewer employees, including doctors,
consultants, real estate agents and business owners. Because the annual contribution limits are
substantially higher than for other types of qualified plans, business owners who have failed to save
sufficiently for retirement may find value in a 412(i). It may also be appropriate for someone with a
substantial tax liability who wants the potential for a significant income tax deduction each year.

In a 412(i), the employer makes contributions, which may be tax deductible up to 100 percent, to the
plan. The contributions are used to purchase and pay ongoing premiums on an insurance contract
covering an employee. The insurance company guarantees a fixed retirement benefit based on the
policy’s cash value. The amount of the benefit, which is calculated using a formula stated in the plan, is
based on each employee’s compensation, age, length of service or a combination of those factors.

Business owners need to be careful about the sources of income used to pay
the premiums on the insurance and annuity policies in a 412(i) plan or risk
contributions not being tax deductible. Passive income can’t be used for
premiums, and subchapter S corporations can’t use the business owner’s
draw.

Contributions to 412i plans can be two to five times greater than
contributions to other types of qualified plans. Contributions come from
pre-tax dollars, thereby reducing the participant’s taxable income. The
insurance can potentially provide a death benefit to beneficiaries if the
participant dies before retiring.

In retirement, a participant can take regular payments up to the annual limit
or an equivalent lump sum, which can be rolled into an
individual retirement account (IRA) or used to purchase a joint-and-survivor
immediate annuity. A participant can also take systematic withdrawals from
the 412(i) insurance and annuity policies. Participants pay ordinary income
tax on distributions. Benefits are guaranteed by the claims-paying ability of
the insurance company, so business owners should conduct thorough due
diligence before selecting a provider. A 412(i) plan can be funded only until
a specific age and no longer. The employee can work past age 65, because
it is a qualified plan, distributions must be taken starting at age 70½.

The business owner can use a third-party administrator to establish and
administer the plan, then claim a partial income tax credit for the
administrative expenses. Initial costs for creating a 412(i) plan may be higher
than for other defined benefit pension plans. Once created, an employer
must make contributions to sustain the minimum-funding requirements,
including annual actuarial calculations. These calculations are, however,
typically simpler than for a 401(k) plan. An employer must ensure that the
company will be able to afford contributions in leaner years.

The IRS has kept a watchful eye on 412(i) plans because of past abuses. Some taxpayers have
attempted to use the plans to tax excessive deductions. The IRS can disallow plans in which the
insurance policy’s surrender value is significantly lower than the premiums paid, artificially inflating the
company’s income tax deduction. Other plans have simply failed to follow the specific rules that apply to
these plans. For this reason, a tax attorney with experience in 412i plans should be consulted to ensure
full compliance with tax law.

In specific circumstances, a 412(i) plan can provide an opportunity for a small business owner or
professional who has delayed retirement saving to catch up with larger contributions than other plans
allow, while realizing a significant tax benefit. During volatile markets, some owners may find the
guarantees provided by the insurance products more attractive than the larger returns of other
investments.

The 412(i) defined benefit pension plan is a tax-qualified retirement plan that must comply with the
Employee Retirement Income Security Act (ERISA), the Internal Revenue Code and other applicable
law.

This article was submitted by Robert Valentine of Financial and Retirement Management.Robert Valentine is a well-known expert in the matters concerning investors. His articles on financial planning matters that concern investors have been published by several publications throughout the United States.