412i plan suitability

412(i) pension plan update – suitability issues

At one time in the late 1990s my OnlineAdviser service received more questions on the topic of 412(i) plans than any other type of retirement plan. This is a bit odd because 412(i) plans are a tiny and relatively obscure method of designing a retirement plan. The simple most likely explanation for this level of activity is that we were one of the few firms offering independent advice on the topic and small business people were able to locate us easily. In more recent years 412(i) pension plans have primarily been marketed by few insurance companies that specialize in this product.

This article is meant to address some general questions surrounding the issues of usefulness and suitability of these retirement plans.

The term “412(i)”comes from the section of the tax code that allows a pension plan to be run without the usual rigorous accounting and documentation. In return for this concession, the plan investments must be completely held by an insurance company. In effect, these are “hybrid” plans, with some characteristics of defined benefit plans and some characteristics of defined contribution plans. The basic intention is to enjoy the benefits of a pension-type retirement plan without the usual costs and paperwork that usually characterize traditional pension plans.

The most common and most effective use of a 412(i) pension retirement plan is in a small business with one older high income employee. This individual has fewer years until retirement and therefore can design a pension plan that requires a high contribution. Higher contributions mean more of the earnings are tax-deductible. The tax deduction might be more than twice the amount allowed by other types of retirement plans. In financial planning lingo, this is the stereotypical “doctor’s plan”, envisioning one older high income professional with a few part-time employees with relatively high employee turnover.

Other situations where a 412(i) plan may be useful:

1) An investor wants to invest in fixed or variable annuities to access the insurance guarantees of principal and (in some cases) earnings. Requests for this type of investment multiply whenever the stock market stumbles. Recent 412(i) plan interest peaked in 2002 and has dropped off in 2003 as the stock market recovered.

2) A small business wants a pension-type retirement plan but balks at the cost of commercial pension services. This situation commonly arises in blue-collar family businesses where the employee/family members are not financially sophisticated and may not be well-qualified to handle their own investments. One business I advised was a father/son fish wholesaler where the son was mentally handicapped. The son did a great job running the sales counter, but his father made sure his son’s pension plan was on auto-pilot before he retired. The son understood and could describe in one simple sentence what would happen when he eventually retired. “My paycheck will keep coming for the rest of my life even if I don’t come to work”.

3) A business owner may wish to move receivables out of the business on a tax-deductible basis. In the example used above, the father was able to ensure that cash for funding the pension would be available from future receipts on the sale of a business property under a lease-purchase agreement. The future income from installments would be offset by annual pension plan contributions. In terms of tax planning,the father effectively transferred some of his own assets (in this case long-term business receivables from an installment sale that would otherwise be counted as income and taxable business assets) out of his estate and into a safe tax-deductible benefit for his son.

4) Where a supplemental income annuity is already being used. Non-qualified annuity plans are handled differently than pension plans for purposes of legal settlements(divorce and other liability settlement situations), college financial aid and other public and private accounting. The core issue is that a pension plan account is a business asset whereas a non-qualified annuity is a personal asset. In some cases, it is simple and desirable to convert this non-deductible personal account to a tax-deductible business plan.

5) An individual who does not need current income and wants to defer 100% of earned income from taxes. This might be the case for a person already finished a career who goes back to work as a consultant. Recent inquiries from semi-retired insurance agents fit this category.

Some examples of situations where 412(i) plans are not suitable or should be used with caution include:

1) The principal or key employee is under age 40. Other traditional retirement plans will generate the same tax results with lower administrative costs and lower tax risk.

2) The desired total annual contribution is less than $50,000. In these cases traditional retirement plan designs are available. Just as above, other traditional retirement plans will generate the same tax results with lower administrative costs and lower tax risk.

3) The plan will be heavily funded with life insurance. Yes, I know it irks some financial marketers when I say this but qualified retirement plans were never meant to be a way to sell a ton of life insurance and the IRS seems intent on proving this point.

4) Where income fluctuates broadly and this might be an isolated “good year” for the owner. Although I have never seen it happen, the IRS can disqualify a plan for not meeting the “permanency” requirements. If a business sets up a pension plan and then discovers that business situation has changed for the worse, the adviser should take extra care to deliberately document the plan termination and rollover to a more suitable plan. A business owner who lets a pension plan die a quiet death is probably at greater tax risk than one who takes proactive measures to terminate a pension plan that no longer fits the current situation.