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

• Author: O'Connell, Frank J., Jr.

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...