It's Back To Playing By The Rules: Sec. 412(i) Retirement Plans

A common expression in the tax arena is the “red flag” ' the concern that a tax deduction is so large, or the tax benefits of a transaction are so favorable to the taxpayer, that it is comparable to waving a red flag at the IRS, inviting scrutiny and possible adverse consequences. Over the past few years, certain retirement plans created under the provisions of Section 412(i) of the Internal Revenue Code have been designed using methods that are questionable, at best, in terms of compliance with the tax code and regulations. This problem became so pervasive that it was widely anticipated the IRS would respond to the red flags, and put an end to the abuses. Last month, it happened. IRS guidance and proposed regulations were enacted to try to get everyone to play by the rules. Not that the rules are bad; a 412(i) plan could still be right for you. First, let's see what this lesser-known retirement plan is all about.

What's A 412(i) Plan?

A Section 412(i) plan is a type of defined benefit retirement plan. A defined benefit plan is a qualified retirement plan in which the eventual annual retirement distribution is a known quantity (defined benefit); the idea is to fund the plan with whatever amount of money it takes to yield this benefit. To contrast, with a defined contribution plan, the annual contribution is predetermined (defined), but the eventual amount of money available to pay out benefits is unknown.

The most unique feature of a 412(i) plan is that it is funded not with cash, but with insurance contracts and annuities. As buyers of whole-life insurance policies are doubtless aware, insurance contracts typically offer a fairly low guaranteed rate of return. Naturally, achieving a specific annual retirement benefit is harder to do with a lower rate of return than with a higher rate; more funding is required. As these higher funding requirements are met in the form of tax-deductible plan contributions, many taxpayers are attracted to the opportunity to avail themselves of the additional tax savings that such higher contributions provide. Currently, we have seen tax deductions for 412(i) plan contributions as high as $300,000 per year for an individual participant. If the plan earns more than the guaranteed rate of return, additional options present themselves. The past contributions are still deductible, while future contributions can be decreased if desired, or plan benefits increased.

One might question the attractiveness of investing in a plan where the rate of return is likely to be low, merely to get a higher income tax deduction. How quickly we forget! The recent bear market ravaged the assets of many a pension plan, and investors may now be in a more conservative frame of mind. Some will trade the possibility of higher rates of return for the guaranteed return of principal (subject to their insurance company's financial stability) that insurance contracts provide, along with a modest return on investment and a heftier income tax deduction.

Another advantage of the 412(i) plan is that it may be funded by insurance that might have been purchased anyway. Effectively, this is like making one's life insurance premiums tax-deductible, thus freeing up funds for other purposes. Plans are fairly flexible as well; they can be custom-designed as to retirement dates and other provisions; Meanwhile, plan assets still enjoy the benefits that make other types of qualified retirement plans attractive, such as tax-deferred growth of plan assets, and the protection of plan assets from creditors.

So, What Went Wrong?

The flexibility to custom-design plans can be a double-edged sword. Being too “flexible” with a plan's provisions and assumptions can cause it to cross the line from a legitimate retirement vehicle to an abusive tax shelter. As it happens, a 412(i) plan is the only type of defined benefit plan that does not require its funding status and plan contributions to be determined by an enrolled actuary. This increases the chance that the terms of a given plan will be deemed unreasonable by the IRS, which could jeopardize the deductibility of plan contributions or even the status of the plan itself. Added to this, some plans were being marketed by overly aggressive sales people who had one thing on their minds ' maximizing the amount of life insurance contracts held by the plan.

One type of abusive plan design addressed last month by the IRS is as follows: The cash surrender value of the insurance policy used to fund the plan does not increase ratably; rather, it retains a very low value for a designated period of time, followed by a very substantial increase in value. During this “window” of low cash surrender value, the policy is either purchased by or distributed to the plan participant or beneficiary. Naturally, the low purchase price, or low taxable income associated with a plan distribution, saves the beneficiary a great deal of money. Shortly thereafter, at the predetermined point when the cash surrender value skyrockets, the beneficiary can borrow against this windfall at little or no cost, while never needing to repay the loan; it is simply deducted from the insurance proceeds after death. Now, bear in mind that that the whole concept of retirement plans is to enable participants to grow their assets faster by allowing them to defer, but not avoid, taxes. Get a deduction when you put money in; pay taxes when you take money out. A plan whose provisions are clearly structured to circumvent the second part of this equation will not pass muster. The new, proposed regulations specify that the transfer of such an insurance contract out of a 412(i) plan, to the beneficiary must be done at the contract's full fair market value.

A separate revenue procedure was also issued by the IRS to help give practitioners interim guidance (until final regulations are issued) as to the fair market value of a life insurance policy. Generally, a plan may treat cash surrender value without reduction for surrender charges as fair market value, provided that at the time of distribution, this value is at least as large as 1) premiums paid plus 2) amounts credited for earnings minus 3) a reasonable mortality charge.

A second IRS ruling precludes the purchase of “excessive” life insurance, which is defined as life insurance whose death benefits exceed what will be payable to the participant's beneficiaries after death. These excess benefits remain in the plan as a form of return on investment, often being used to pay the premiums under the plan with respect to other participants. Such arrangements are now ' get out the red flag ' generally considered “listed” transactions for tax-shelter reporting purposes. Not a good place to be.

Can I Still Set Up A 412(i) Plan?

Yes you can. Abusive plans have been curtailed, but if you never intended to go that route then nothing has changed. Section 412(i) has been around since ERISA (the Employment Retirement Income Security Act) was passed in 1974, which means it predates many of the more commonly known retirement plans. The main advantages, documented above, center around one's risk tolerance (or lack thereof), and one's predisposition to trade the potential for large gains in the equity markets, for security and enhanced tax deductions. Realize, however, that the party selling you the plan and the policy that funds it may not be in the best position to offer an impartial opinion as to the plan's merits, in terms of whether it will attract or stand up to possible IRS scrutiny. For this, you are well advised to seek the advice of a qualified pension specialist. As it is early in the year, there is plenty of time to evaluate your options and perform due diligence before putting a plan in place.

A common expression in the tax arena is the “red flag” ' the concern that a tax deduction is so large, or the tax benefits of a transaction are so favorable to the taxpayer, that it is comparable to waving a red flag at the IRS, inviting scrutiny and possible adverse consequences. Over the past few years, certain retirement plans created under the provisions of Section 412(i) of the Internal Revenue Code have been designed using methods that are questionable, at best, in terms of compliance with the tax code and regulations. This problem became so pervasive that it was widely anticipated the IRS would respond to the red flags, and put an end to the abuses. Last month, it happened. IRS guidance and proposed regulations were enacted to try to get everyone to play by the rules. Not that the rules are bad; a 412(i) plan could still be right for you. First, let's see what this lesser-known retirement plan is all about.

What's A 412(i) Plan?

A Section 412(i) plan is a type of defined benefit retirement plan. A defined benefit plan is a qualified retirement plan in which the eventual annual retirement distribution is a known quantity (defined benefit); the idea is to fund the plan with whatever amount of money it takes to yield this benefit. To contrast, with a defined contribution plan, the annual contribution is predetermined (defined), but the eventual amount of money available to pay out benefits is unknown.

The most unique feature of a 412(i) plan is that it is funded not with cash, but with insurance contracts and annuities. As buyers of whole-life insurance policies are doubtless aware, insurance contracts typically offer a fairly low guaranteed rate of return. Naturally, achieving a specific annual retirement benefit is harder to do with a lower rate of return than with a higher rate; more funding is required. As these higher funding requirements are met in the form of tax-deductible plan contributions, many taxpayers are attracted to the opportunity to avail themselves of the additional tax savings that such higher contributions provide. Currently, we have seen tax deductions for 412(i) plan contributions as high as $300,000 per year for an individual participant. If the plan earns more than the guaranteed rate of return, additional options present themselves. The past contributions are still deductible, while future contributions can be decreased if desired, or plan benefits increased.

One might question the attractiveness of investing in a plan where the rate of return is likely to be low, merely to get a higher income tax deduction. How quickly we forget! The recent bear market ravaged the assets of many a pension plan, and investors may now be in a more conservative frame of mind. Some will trade the possibility of higher rates of return for the guaranteed return of principal (subject to their insurance company's financial stability) that insurance contracts provide, along with a modest return on investment and a heftier income tax deduction.

Another advantage of the 412(i) plan is that it may be funded by insurance that might have been purchased anyway. Effectively, this is like making one's life insurance premiums tax-deductible, thus freeing up funds for other purposes. Plans are fairly flexible as well; they can be custom-designed as to retirement dates and other provisions; Meanwhile, plan assets still enjoy the benefits that make other types of qualified retirement plans attractive, such as tax-deferred growth of plan assets, and the protection of plan assets from creditors.

So, What Went Wrong?

The flexibility to custom-design plans can be a double-edged sword. Being too “flexible” with a plan's provisions and assumptions can cause it to cross the line from a legitimate retirement vehicle to an abusive tax shelter. As it happens, a 412(i) plan is the only type of defined benefit plan that does not require its funding status and plan contributions to be determined by an enrolled actuary. This increases the chance that the terms of a given plan will be deemed unreasonable by the IRS, which could jeopardize the deductibility of plan contributions or even the status of the plan itself. Added to this, some plans were being marketed by overly aggressive sales people who had one thing on their minds ' maximizing the amount of life insurance contracts held by the plan.

One type of abusive plan design addressed last month by the IRS is as follows: The cash surrender value of the insurance policy used to fund the plan does not increase ratably; rather, it retains a very low value for a designated period of time, followed by a very substantial increase in value. During this “window” of low cash surrender value, the policy is either purchased by or distributed to the plan participant or beneficiary. Naturally, the low purchase price, or low taxable income associated with a plan distribution, saves the beneficiary a great deal of money. Shortly thereafter, at the predetermined point when the cash surrender value skyrockets, the beneficiary can borrow against this windfall at little or no cost, while never needing to repay the loan; it is simply deducted from the insurance proceeds after death. Now, bear in mind that that the whole concept of retirement plans is to enable participants to grow their assets faster by allowing them to defer, but not avoid, taxes. Get a deduction when you put money in; pay taxes when you take money out. A plan whose provisions are clearly structured to circumvent the second part of this equation will not pass muster. The new, proposed regulations specify that the transfer of such an insurance contract out of a 412(i) plan, to the beneficiary must be done at the contract's full fair market value.

A separate revenue procedure was also issued by the IRS to help give practitioners interim guidance (until final regulations are issued) as to the fair market value of a life insurance policy. Generally, a plan may treat cash surrender value without reduction for surrender charges as fair market value, provided that at the time of distribution, this value is at least as large as 1) premiums paid plus 2) amounts credited for earnings minus 3) a reasonable mortality charge.

A second IRS ruling precludes the purchase of “excessive” life insurance, which is defined as life insurance whose death benefits exceed what will be payable to the participant's beneficiaries after death. These excess benefits remain in the plan as a form of return on investment, often being used to pay the premiums under the plan with respect to other participants. Such arrangements are now ' get out the red flag ' generally considered “listed” transactions for tax-shelter reporting purposes. Not a good place to be.

Can I Still Set Up A 412(i) Plan?

Yes you can. Abusive plans have been curtailed, but if you never intended to go that route then nothing has changed. Section 412(i) has been around since ERISA (the Employment Retirement Income Security Act) was passed in 1974, which means it predates many of the more commonly known retirement plans. The main advantages, documented above, center around one's risk tolerance (or lack thereof), and one's predisposition to trade the potential for large gains in the equity markets, for security and enhanced tax deductions. Realize, however, that the party selling you the plan and the policy that funds it may not be in the best position to offer an impartial opinion as to the plan's merits, in terms of whether it will attract or stand up to possible IRS scrutiny. For this, you are well advised to seek the advice of a qualified pension specialist. As it is early in the year, there is plenty of time to evaluate your options and perform due diligence before putting a plan in place.