Defining Benefits: Are 412(e)(3) Plans Good for Small Businesses?
California CPA magazine: October 2008
A major goal of the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was to encourage the establishment of small-business retirement plans. Since then, as an incentive to small-business owners, the tax-deductible dollar limit and compensation percentage for such plans has increased. In 2008, the maximum contribution limit for defined-contribution plans under IRC Sec. 415(c)(I)(A) is $46,000. Participants at age 50 or more are allowed an additional catch-up limit of $5,000.
While Sec. 401(k) plans are common, they limit a business’ tax-deductible contributions. Because of recent tax-law changes (provided by EGTRRA and the Pension Protection Act of 2006), which amend the Employee Retirement Income Security Act by establishing new minimum pension funding standards, many companies are eligible for a 401(k) plan, as well as defined-benefit and profit-sharing plans. Your awareness of these changes will enable you to provide new options to your clients.
A defined-benefit plan is a qualified plan where a pre-determined formula sets the amount of retirement income received by a participant. With a traditional defined-benefit plan, the size of the tax-deductible contribution made to fund retirement income benefits under the plan is calculated annually.
The actual deductible contributions are determined by a complex set of mathematical calculations and regulatory requirements, which must be performed by qualified actuaries. Depending on the age of the participants and benefit levels provided, a defined-benefit plan can achieve tax-deductible contributions well in excess of Sec. 415 limits.
However, the ability of these types of plans to generate significant contributions also adds to the complexity and reporting requirements. Annual contributions and deductions are calculated each year and are affected by, among other things, actual earnings or losses from investment of the trust assets, actuarial assumptions and limitations imposed by the minimum funding standards and full funding limitations of IRC Sec. 412. As a result, administration costs tend to be
higher for these plans then for defined contribution plans.
An alternative is to use a Sec. 412(e)(3) plan—referred to in the IRS regulations as an “insurance contract plan”—that is exempt from the funding requirements of IRC Sec. 412.
The Fully Insured Plan Solution
Sec. 412(e)(3) plans are exempt from the section’s funding rules described above because the burden of providing the benefit is shifted from the employer to an insurance company. Prior to the Pension Protection Act of 2006, these plans were known as 412(i) plans. They are referred to as a “fully insured” plan because the benefits are guaranteed by an insurance company (subject to its claims paying capacity).
Fully insured, defined-benefit plans are unique in the retirement planning arena because they have a higher tax-deduction limit than most plans. Moreover, plan contributions may be greater than those made to traditional defined-benefit plans because they are funded using fixed-annuity products. Whole-life insurance may also be included.
Also, the interest-rate assumptions are much more conservative in these types of contracts than in a traditional defined-benefit plan. This allows for a greater deduction. While contributions (which are based on guaranteed interest and mortality assumptions) to a fully insured plan generally remain high, they can decrease over time if the assets contributed toward the plan earn dividends or interest over and above the guaranteed levels. In this situation, these “extra” earnings must be used to offset contributions.
The accrued benefit for a participant at retirement is a stated monthly pension, or simply the guaranteed cash values of the underlying policies. Business owners and professionals might appreciate the ability to set aside large amounts of money each year, while taking large tax deductions for doing so—as well as the fully guaranteed retirement benefits the plans provide.
The retirement payout is subject to the same IRS limits as all other defined-benefit retirement plans. For 2008, the maximum annual amount that can be received by each participant is generally the lesser of $185,000 or 100 percent of the participant’s average compensation for the highest three years of work. And just like a traditional defined-benefit plan, as an alternative to taking periodic distributions from the fully insured plan, a participant may take a lump sum and roll the assets
into an IRA.
Who Qualifies for a 412(e)(3) Plan?
By and large, 412(e)(3) plans are ideal for business owners with relatively few employees that can commit to making large, regular contributions. The concept works best for businesses that are well-established and highly profitable.
The plan is equally suited to successful, self-employed individuals, who may have been unable to set money aside for retirement in their early years, due to family or other obligations, and now need to put away large amounts of money in a short amount of time. Individuals starting a second career are also good candidates for these plans, as are those who want to provide for family members and heirs should they die unexpectedly. Note that any life-insurance contract transferred from a plan to the individual employee must be taxed at its full fair-market value, and an employer may not buy excessive life insurance under a plan.
Also, Sec. 401(a)4 discrimination testing could allow business owners to receive a substantial portion of the plan’s benefit for themselves. A feasibility study should be performed by a qualified pension consultant to determine the right type of plan and its cost and benefits.
Easier to Use
Employers may find 412(e)(3) plans attractive because they avoid the complications commonly associated with traditional defined-benefit plans. For example, no enrolled actuary’s certification is needed; there are no required quarterly contributions; there is no full funding limitation applied that might limit contributions; and administrative costs are generally lower. Another popular feature includes protection of plan assets from lawsuits and creditors.
A third-party administrator will establish the plan, which includes providing the plan and trust documents and providing the plan trustee with all documents and administrative forms that may be needed in the future. The administrator also provides annual processing of all IRS and Department of Labor forms, plan valuation and 5500 forms.
Next Steps?
Many small-business owners with successful and mature businesses have higher incomes and assets than traditional wage earners. But this doesn’t always translate into higher retirement savings. According to a 2004 study by The Public Policy Institute of the AARP, only 12 percent of self-employed individuals over age 50 have a pension or retirement plan, and their average account balance is just a little more than $70,000. Professionals such as doctors, architects, lawyers and individuals with second incomes may benefit from the flexibility of a fully insured defined-benefit plan. And let’s not forget CPAs, too.
I believe these tax law changes create opportunities for CPAs to help clients increase tax deductions through retirement plans, increase baby boomer retirement income and enhance the CPAs relationship with their clients. For a calendar tax year business, the new plan must be adopted by Dec. 31 and funded by the tax due date (including extensions).
Philip R. Lieberman, CPA/PFS is an independent business consultant and financial services professional for First Choice Financial Group. You can reach him at phil@fcfg.net.
