Section 412(i) defined benefit plans: simplicity, safety, and power.

• Author: Koresko, V, John J.

In the months since the Enron debacle (1) came to light, many people have questioned the potential dangers of 401(k) and other forms of defined contribution plans and the merits of a guaranteed retirement income stream found in defined benefit (DB) pension plans. Although lacking the "sexiness" of the potential stock market home run, DB plans remove the gamble in favor of a retirement income stream for life. DB plan benefits are legally enforceable under ERISA. Benefits are even guaranteed up to about $42,000 annually by the Pension Benefit Guaranty Corporation (PBGC). Since 1971, there has been an astounding reduction in the numbers of DB plans, with expense of operation and complexity being the commonly given reasons.

In the last several years, planners have rediscovered the utility of DB plans, especially [section] 412(i). Section 412(i) of the Internal Revenue Code ("Code") provides an exemption from certain funding requirements if a qualified plan satisfies the requirements of that subsection. Those requirements and other issues involving 412(i) plans are discussed in the following questions, answers, and tables. Lawyers and their clients should know their options in this environment of fewer and fewer income tax advantages.

Q: What is a 412(i) plan?

A 412(i) plan is a defined benefit plan whose funding (annual contribution) is calculated under the rules of Code [section] 412(i). It is also referred to as a fully insured plan. Perhaps the least technical way to describe a 412(i) is private social security, guaranteed by both the government and an insurance company.

Q: Why should an employer seek to qualify a plan under [section] 412(i)?

If a plan qualifies under Code [section] 412(i), it is exempt from the other funding requirements of Code [section] 412, including: a) the minimum funding standard account; b) the full funding limitation; c) quarterly contributions; d) actuarial assumptions imposed by the IRS; and e) the Schedule B enrolled actuary's certification otherwise required with the Form 5500 for the plan.

Q: What is the difference between a 412(i) plan and any other defined benefit plan, and how does the difference affect contributions?

Only the funding assumptions are different. A 412(i) plan must meet all requirements of the Code relating to eligibility, participation, coverage, distributions, maximum benefit, and so on. In a traditional defined benefit plan, an enrolled actuary certifies reasonable actuarial interest assumptions and completes a Schedule B for filing with Form 5500. Under a 412(i) plan an enrolled actuary is not necessary, because the plan's assumptions are based on the guarantees of the insurance contracts. Typically, the contract guarantees are much lower than the interest assumptions used under a traditional defined benefit plan. This results in higher contributions (deductions) under a 412(i) plan as compared to all other retirement plans.

Just like traditional pension plans, an employer may exceed the $41,000 contribution limitations of defined contribution plans. Table 1 below illustrates the large deduction possibilities for an employer who desires a pension payment of $165,000 per year:

Q: What requirements must the plan meet to qualify under Code [section] 412(i)?

Generally, the requirements for qualification of a plan as a 412(i) plan are as follows:

1) The plan must be funded exclusively with insurance contracts, defined by the regulations as annuity contracts or a combination of insurance policies and annuity contracts;

2) The contracts must provide for level annual premium payments to begin when the individual becomes a plan participant and extending not later than the retirement date under the plan;

3) The plan's benefits at normal retirement age must be guaranteed by the insurance carrier who issues the contracts to the extent premiums have been paid;

4) Premiums payable for the plan year and all prior plan years under such contracts must have been paid;

5) No rights under the contracts may be subject to a security interest during the plan year; and

6) No policy loans may be outstanding at any time during the plan year.

Q: In addition to annuities, can life insurance be used as a plan funding vehicle?

Yes. In fact, very large amounts are possible in some situations where there is a need for death benefit protection. In certain situations, joint life policies may be used.

Q: Can a self-employed individual or partnership establish a 412(i) plan?

Yes. Individuals and small entities must, however, be careful if they have income that fluctuates significantly from year to year. The plan is not generally suitable for self-employed individuals unless the individual has experienced stable past earnings and expects future earnings to be similarly sufficient to fund the plan in the future. On the other hand, a sole proprietor or sole shareholder with no employees cannot find a more efficient retirement and financial planning arrangement. Tax deductible life insurance is always better than paying premiums with after-tax money. Proprietors and small businesspersons (including lawyers) are in most need for a stable retirement arrangement. Table 2 below illustrates one scenario with a benefit equal to 100 percent of salary.

Q: Can any insurance company handle a plan intended to qualify under [section] 412(i)?

It was previously promoted among certain companies that an insurance carrier whose products are designed to meet the requirements of Code [section] 412(i) must be used for funding a 412(i) plan. That conclusion is not supported by the statute or regulations. Reg. [section] 1.412(i)-l(b)(ii) provides that contracts which do not initially qualify may be modified by an extra-contractual agreement between the plan and the insurance company. Most insurance companies, however, cannot do this nor illustrate advanced techniques like cross-testing. Such design usually requires the assistance of a specialist.

Q: Can variable insurance and annuity products be used to fund a 412(i) plan?

Yes. A business process has...