412e3 (Formally 412i

WHAT IS A 412e3 FULLY INSURED PLAN?

A 412e3 Fully Insured Plan, formerly known as 412i Fully Insured Plan, referred to in the IRS regulations as an "insurance contract plan," is a special type of defined benefit plan. It is called a "fully insured" plan because the benefits are guaranteed* by an insurance company. A 412e3 Plan is not subject to many of the requirements that have made traditional defined benefit plans unpopular over the years. These plans have become even more popular lately because changes in the tax laws over the last few years have made them more attractive. Since the investments in these plans are based on fixed accounts with retirement benefits guaranteed*, they are getting a second look now that there is so much volatility in the equity markets.

WHAT IS THE DIFFERENCE BETWEEN A DEFINED BENEFIT AND A DEFINED CONTRIBUTION PLAN?

Both are qualified retirement plans and contributions to these plans receive a current tax deduction. In a defined benefit plan, risk is borne by the employer to provide for a certain future benefit at the employee's retirement. The benefit is based on a formula selected by the employer which takes into account the employee's income level and number of years of employment with the employer. It is the employer's responsibility to make sure that the funding is adequate to reach the pre-determined benefit amount.

A defined contribution plan is a plan such as a profit sharing plan or a 401(k) plan where the benefit level is dependent on contributions and investment returns. In this type of plan, the employee bears the risk on the ultimate amount of their benefit. There is no guarantee of the future value at retirement; it is predicated on the level of contributions and on investment returns.

WHY IS A 412e3 PLAN NOT SUBJECT TO THE FUNDING REQUIREMENTS OF A TRADITIONAL DEFINED BENEFIT PLAN?

412e3 Plans get their name from the sub-section of the tax code that provides an exemption to the minimum funding requirement of Section 412. As long as the plan follows certain requirements, the exemption is available. The requirements are listed below:

• The plan must be funded exclusively by the "purchase of individual insurance contracts."

• The contracts must "provide for level annual premium payments."

• The benefits provided under the plan must be "guaranteed by an insurance carrier (licensed under the laws of a State to do business with the plan) to the extent premiums have been paid."

• The life insurance products funding the plan can have "no policy loans outstanding at any time during the plan year."

• The exemption to minimum funding requirements is granted because an insurance company is guaranteeing the benefits "to the extent premiums have been paid."

 

HOW DID THE TAX LAW CHANGES IN THE LAST FEW YEARS IMPACT 412e3 PLANS?

412e3 Plans were previously called 412i Plans. The Pension Protection Act of 2006 consolidated code in Section 412 down to five subsections.

As a result, the provisions for fully insured plans were moved to Section 412e3.

In a defined benefit plan, risk is borne by the employer to provide for a certain future benefit at the employee's retirement. A defined contribution plan is a plan such as a profit sharing plan or a 401(k) plan where the benefit level is dependent on contributions and investment returns. In this type of plan, the employee bears the risk on the ultimate amount of their benefit.

HOW DOES THE INSURANCE COMPANY GUARANTEE THE BENEFITS?

412e3 Plans are funded with specific insurance products (annuities and life insurance.) These are fixed products which have a guaranteed* and a current interest rate. After the retirement benefit is decided upon, the initial contributions to the plan are calculated using the guaranteed* interest rates in the insurance products. Any life insurance dividends or excess annuity interest are required to be used to reduce the following year's contribution.

WHAT HAPPENS TO THE CONTRIBUTION AMOUNT OVER TIME?

If the benefit to be paid at retirement remains the same, the contributions to a 412e3 Plan to fund that benefit will decrease over time as the current interest and dividends that exceed the guaranteed* rates are used to reduce future contributions.

CAN THE BENEFITS TO BE PAID AT RETIREMENT CHANGE DURING THE LIFE OF THE PLAN?

Yes, if W-2 changes. Since the benefit is based on a pension formula that takes into account the W-2 of the participant, if the W-2 changes then the benefit to be paid changes. Each year the Plan administrator reviews the W-2's of the participants and adjusts the benefits to be paid.

HOW DOES THAT AFFECT THE CONTRIBUTION TO THE PLAN?

If benefits increase or decrease then the funding to reach them would increase or decrease also.

BUT THE CONTRIBUTIONS TO A 412e3 PLAN WILL TEND TO BE GREATEST IN THE EARLY YEARS?

Yes, all things being equal. This is considered to be one of the advantages of the 412e3 Plan over a traditional defined benefit plan. In a traditional defined benefit plan, the contributions tend to increase over time. However, since the contributions to a 412e3 Plan are greatest in the early years and then decrease, they are easier for a business to plan for.

DOES EVERY EMPLOYEE HAVE TO BE INCLUDED IN A 412e3 DEFINED BENEFIT PLAN?

Only those employees over the age of 21 and working more than 1,000 hours need to be included in the Plan. In addition, those employees benefiting from a union plan may be left out. In order to become fully vested in the Plan, employees may have to stay with the company for a period of time.

If the benefit to be paid at retirement remains the same, the contributions to a 412e3 Plan to fund that benefit will decrease over time as the current interest and dividends that exceed the guaranteed* rates are used to reduce future contributions.

WHAT IS THE VESTING SCHEDULE FOR A 412e3 PLAN?

The vesting schedule on a 412e3 Plan is dependent on the eligibility period chose. This is the period of time chosen before an employee becomes eligible to be part of the Plan. If there is a two year wait, the employee is 100% vested. If the Plan has a one year wait, then the vesting schedule can follow the chart below.

Five year vesting - employee who has completed at least 5 years of service has a non-forfeitable right to 100 percent of the employee's accrued benefit derived from employer contributions.

Three to seven year vesting - employee has a non-forfeitable right to a percentage of the employee's accrued benefit derived from employer contributions determined under the following table:

Years of Service - The Non-forfeitable Percentage is:

• 3 Years - 20%

• 4 Years - 40%

• 5 Years - 60%

• 6 Years - 80%

• 7 or more Years - 100%

 

WHAT HAPPENS WHEN PARTICIPANTS LEAVE THE PLAN?

The accrued values that would be distributed to participants would be the surrender values in the annuity and life insurance contract funding their 412e3 Plan. The distribution would be subject to the vesting requirement of the plan so that all of the accrued value may not be distributed. Alternatively, subject to the vesting schedule, the participants could also take an in-kind distribution of their policies.

WHAT HAPPENS TO THE ACCRUED VALUES THAT WOULD NOT BE DISTRIBUTED SINCE THEY WERE SUBJECT TO THE VESTING REQUIREMENTS?

The forfeited values would be used to lower future contributions. Forfeited values cannot be used to increase another participants' benefit, only to help fund existing designed benefits.

WHY WOULD LIFE INSURANCE BE USED TO FUND THE PLAN?

For some, the ability to "guarantee" a retirement income for loved ones with the death benefit provided by life insurance is reason enough to include life insurance. The ability to purchase life insurance on a pre-tax basis can make economic sense ... and ultimately increase your deduction.

ARE THERE LIMITS TO THE AMOUNT OF LIFE INSURANCE THAT CAN BE PROVIDED?

Yes, the death benefit is limited to 100 times expected monthly benefit, or an amount purchased, by up to 66-2/3% of the theoretical level premium of a non-insured 412e3 Plan.

DOES THE INCLUSION OF LIFE INSURANCE AFFECT THE RETIREMENT BENEFIT PROVIDED?

No. The retirement benefit provided by the 412e3 Plan is not affected by the inclusion of life insurance; it will remain the same. However, the inclusion of life insurance will increase the tax-deduction to the Plan to compensate for the mortality charge in the life insurance contract. The life insurance cash value at retirement is considered to be a part of the benefit provided by the Plan and is added to the annuity value to provide the retirement benefit.

ARE THERE ANY COSTS TO EMPLOYEES FOR INCLUDING LIFE INSURANCE IN THE PLAN?

Yes. Since there is a current economic benefit from the pure life insurance coverage (death benefit minus cash value in policy) Plan participants must include in their taxable income each year an amount based on the Table 2001 rates published by the government. For a sole proprietor, there is no tax paid on the economic benefit, instead the tax deduction taken for the contribution is reduced by the economic benefit cost.

WHO IS THE OWNER AND BENEFICIARY OF THE LIFE INSURANCE POLICY?

The owner and beneficiary of the policy would be the Plan's trust. The life insurance benefit would be distributed according to the beneficiary designation in the Plan.

IS THE DEATH BENEFIT INCOME TAXABLE WHEN RECEIVED BY HEIRS?

The amount of death benefit in excess of the cash value in the policy would be received income tax free by the beneficiaries. The cash value amount may be subject to income tax.

CAN THE LIFE INSURANCE POLICY INCLUDE WAIVER OF PREMIUM?

The waiver of premium feature on a life insurance policy funds the life insurance policy in the case of a disability of the insured. This feature can be added to policies used in 412e3 Plans and provides a valuable "self completing" feature for the Plan participant.

DOES THE LIFE INSURANCE HAVE TO BE ONLY ON THE LIFE OF THE PLAN PARTICIPANT OR CAN SURVIVORSHIP LIFE INSURANCE BE USED?

Only a single life policy on the life of the participant can be used. Survivorship life cannot be used.

WHAT HAPPENS TO THE LIFE INSURANCE POLICY WHEN A PARTICIPANT LEAVES THE PLAN OR THE PLAN IS TERMINATED?

There are a number of options, some of which are listed below:

Surrender the policy, making the surrender value part of the 412e3 plan assets.

This is usually done if the plan participant is going to utilize a Rollover IRA for plan assets since an IRA cannot hold life insurance. The policy is terminated and the entire assets of the plan are rolled over into a self directed IRA.

Distribute the policy from the plan to the plan participant.

The value of the policy at distribution would be based on the "fair market" value of the policy at time of distribution. The participant would have income due on that amount since this would be deemed a distribution from the plan.

Buy the policy from the plan.

The value of the policy would be the "fair market" value of the policy at the time the policy was purchased. The policy could not be purchased by a "disqualified person," though a sale to a Grantor Trust (ILIT) is possible. This should be done only after consultation with a qualified attorney who has knowledge in both Estate Planning and ERISA issues.