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412(i) Plan Is Complex But A Boon In Some Situations

If you own a small business or professional practice with five or fewer employees and have already maxed out your defined contribution plan, you may want to consider a little-known type of defined benefit plan known as a 412(i) plan.

The 412(i) is designed for small-business owners and professionals who need to move large amounts of money into a pension plan. It’s a type of defined-benefit retirement plan but differs from traditional defined-benefit plans because it must be funded entirely through annuities or other insurance products that have a minimum rate of return that is guaranteed by the full faith and credit of an insurance company. Since that insurer-backed rate of return is normally lower than the rate used to calculate contributions to traditional defined-benefit plans, you can contribute far more to a 412(i) than to a traditional defined-benefit plan.

The 412(i) is a good vehicle to consider if you’re in your 50s or 60s and have been unable to save enough for retirement until now. If you’ve been pouring money into college tuition, home renovations, and a vacation home and have neglected to save enough for retirement, this is a "catch-up" vehicle. As a business owner, you can put away a maximum of $54,000 in 2017 in a 401(k) plan—plus another $6,000 a year if you’re age 50 or older. The 412(i) plan let’s you sock away far more.

It’s important to understand that the maximum benefit from a 412(i) is the same as any other defined-benefit plan, currently $215,000 a year at retirement age. But since you can assume a lower rate of return with a 412(i), you must contribute more each year to fund the $215,000 annual benefit.

Contributions are tax-deductible, of course, and your larger contributions entitle you to bigger tax deductions. That offsets the lower return rate of a 412(i).

In addition, the 412(i) provides flexibility in how you can draw down on your money. The 412(i) can be rolled over to an IRA, withdrawn as cash (on which you must pay ordinary income tax), or converted to a lifetime annuity. 412(i) plans eliminate the risk that deviations in investment return may create the possibility of overfunding or underfunding your defined benefit plan, which can draw taxes and penalties of 80% or more.

Also, using a 412(i) plan can save you a big step: Because the contribution to a 412(i) is the premium on the annuity or life insurance policy, you don’t have to hire an actuary to calculate your annual funding requirements.

But the annuity in the 412(i) can also be a disadvantage. The rate of return, since it is guaranteed by the insurer, could be lower than what you might otherwise get by investing in stocks or stock mutual funds. And costs associated with annuities are generally higher than with other investment vehicles.

If you set up a 412(i) plan, it’s important to remember that your contribution level, for yourself and for any employees, is fixed. You have to put the same amount in every year. So if you set that bar high, you must be confident that your business is strong enough to weather downturns and still make your contribution.

You’ll also need to avoid what the IRS considers abusive 412(i) set-ups in which unrealistically low returns on annuities or life policies are used to inflate annual contributions—and business tax deductions. Annuity rates of less than 2% may signal an abusive plan. Another potential for abuse is high expenses. You must examine the annual cost of managing the assets, administration and recordkeeping expenses charged by the insurer, and the sales loads such products may generate.

A final consideration: Since the guarantees on an annuity in a 412(i) plan depend on the financial strength of the issuing life insurance company, it’s crucial to choose a reputable, creditworthy company that can withstand shocks to the economy and that has not taken big risks with its investments.

412(i) plans are complex. For instance, in calculating how much you can contribute, the IRS will allow you to consider only up to $270,000 of your salary for 2017. The IRS limits the amount of life insurance you can buy within these plans, and loans are not permitted. If you are a business owner, and want to find out whether a 412(i) plan is right for you, please give us a call.