Use of life insurance in small business 412(i) pension plans

Update December 2014: The advice and references in this article are still valid today but pension industry trends have shifted over the past ten years. The term “412(i) pension plan” refers to a plan that uses an insurance product as the exclusive funding vehicle. The primary attraction of 412(i) pension plans, especially for one person pension plans, was lower administrative cost because the IRS does not require an actuary’s report for these fully insured pension plans. Administrative costs are lower today (especially as measured as an annual percentage of plan assets) for regular pension plans so the need to find creative ways to avoid those costs is diminished. Additionally, the appropriateness of designing a pension plan in a manner that limits the choice of funding vehicles to only insurance products must be called into question. The use of life insurance or annuities in single person pension plans is more a matter of personal preference today and not so much driven by any economic motive. As a result, some professional practices – including mine – will help clients accommodate the use of life insurance and annuities within a pension plan but not in lieu of an actuary’s report. In this case there is no longer any need to refer to such pensions as “412(i) plans”.

The IRS clarified three important points for pension plans that use life insurance in February 2004:

1.  A tax-qualified pension plan may not provide life insurance benefits in excess of the previously stated maximums. In general, this maximum amount is 100 times the monthly pension benefit.

2.  The cost of life insurance that is more than the allowable amount is not tax-deductible as a current year’s contribution to the retirement plan.

3.  Life insurance contracts may not be sold or transferred out of a pension plan for the amount of their cash value that is significantly less than the amount paid for the insurance policy.

While pension plans may contain some life insurance to provide incidental death benefits, some life insurance promoters have used life insurance almost exclusively to fund pension plan benefits. Some companies incorrectly promoted life insurance policies as a way to increase tax-deductible contributions to a pension plan. The IRS has consistently held that such practices were abusive.  The current rulings issued in February 2004 are designed to clarify these positions. Details can be found in Revenue Ruling 2004-20 (deductible contributions) and Revenue Ruling 2004-21 (non-discrimination within insured pension plans).

Business owners with pension plans that are funded primarily with life insurance should seek advice from a source other than the life insurance sales system.  Those who relied on advisory or legal services provided by the life insurance company may wish to raise the question as to whether the advice was objective and consistent with industry standards.

It appears that some small business pension plans do not meet these requirements and that the small business sponsors would be hurt financially by enforcement of these new revenue rulings. It appears that the focus of IRS enforcement is on curbing improper sales practices of 412(i) pension plans. Attorneys seeking to substantiate charges of improper sales practices may wish to gather evidence of IRS statements and industry publications on the topic of the known and publicized abusive practices that were known prior to the date of sale of the life insurance policy in question.

Additional resources

Pension plans for small businesses

Pension plan design benchmarks

412(i) self-employed pension plans

412(i) pension plan suitability

 

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