Your 412(i) Source

We at Phillips and Associates are experts at providing asset protection, including 412(i) plans.

A decade ago defined benefit plans were routinely used by retirement planners. Doctors could fund their retirement based upon actuarial tables, and for older doctors starting a plan, contributions could be very large because the entire plan had to be funded in the few years remaining before retirement. The large contributions equated to large tax deductions.

Defined benefit plans had a wet blanket put on them by the 1987 tax acts and it has taken them a decade to find favor again with retirement planners. The onerous restrictions placed on defined benefit plans in §412 of the 1987 act required quarterly contributions with stiff penalties for improper funding of the plan if the amounts and timing of the contributions were not just right.

If the plans were terminated, the law exacted penalties on the reversion of excess assets to the company (doctor) sponsoring the plan. The laws put "full funding limitations" on the plans which reduced deductions or totally eliminated the deductions for contributions. Additionally, the actuarial assumptions used to design the plans became much more complex.

The bottom line was, the more complex rules, penalties, and smaller deductions made the plans less attractive. The plan sponsor also had to "lump together" defined contribution plans (profit/pension plans, 401(k) plans, etc.) and defined benefit plans to derive the retirement benefit that could actually be funded by the defined contribution plan. Many defined benefit plans are in trouble today because they are "over funded" according to the IRS.

Today, the use of §412(i) provides a way around the problems of traditional defined benefit plans. For a small business, such as a medical office, a defined benefit plan which qualifies under §412(i) of the IRS code is an ideal tax shelter and planning vehicle, because the plan is exempt from all of the other 412 rules. To qualify under 412(i), the following elements must be in the plan.

1. The plan must be fully insured, i.e., the plan must be funded using only life insurance and/or annuity products. Thus, the plan is often called an "insurance contract plan" or a "fully insured plan." The insurance policies and annuities must require level annual premiums and must be equal to the full benefit promised by the plan.

2. Premiums must be paid from the time a participant enters the plan until his or her retirement, but quarterly contributions are not required. Any life insurance dividends and excess annuity interest, above that necessary to fund the established benefit, must be applied toward the next year's required contribution. In some cases, the plan can become at least partly self funding.

3. No loans can be taken from the plan funds.

A 412(i) plan has a number of significant advantages over a traditional defined benefit plan. For example, it doesn't require the complex actuarial work that a traditional defined benefit plan does, and it is not subject to the full funding limitation tests. It is required to use the annuity or life insurance guaranteed rates of return to calculate all of its planning assumptions. If the guaranteed rates of return are used, it is not subject to attacks from the IRS for unreasonable funding like traditional defined benefit plans are.

Because the insurance company's guaranteed rates form the basis for all planning assumptions, you could end up with a bigger retirement fund than "projected." Historically, insurance companies have paid a higher rate than their "guaranteed" rate. Therefore, a plan which has funded a specific benefit might have up to 50% more actual cash than originally planned. Instead of ending up with $1 million in the plan, you could end up with $1.4 million, and the plan will not be considered "over funded" by the IRS.

Maybe the best advantage of a 412(i) plan is the ability it gives you to make larger tax deductible contributions. Again, the plan assumptions must be based on the insurance company's guaranteed rates of return. Making some broad assumptions about rates of return, if you are 50 years old and start funding the plan, you can write off up to $86,755 per year until retirement, as compared to $64,775 in a traditional plan. If you start the plan at age 60, the annual deductions can be as high as $166,490, as compared to $109,700. That gives you an additional 52% contribution (deduction).

If it is designed properly, a 412(i) plan won't have the problem of excess assets that subjects many defined benefit plans to taxes and penalties of 80% or more when the plan is terminated. In fact, the 412(i) can be used to protect an over funded defined benefit plan. Rather than terminating the over funded plan, it can often be converted into a 412(i) plan, and the taxes and penalties can be eliminated while preserving the full benefit. The over funded plan must be analyzed to see if it is possible to convert it to a 412(i) plan, but many can be easily converted, and that solves a huge problem.

Small businesses, doctors that are "moonlighting," and doctors in a stable practice can certainly use the 412(i) to help control current income taxes, shelter income from the sale of a practice or other asset, and provide a secure retirement. The 412(i) is very straightforward and very well defined in the IRS code.

Beginning January 1, 2000 the 412(i) gets a lot better, because you can have a 412(i) plan and a defined contribution plan stacked on top of each other, and the two plans don't have to be lumped together to determine the ultimate retirement benefit you can plan for and the deductions you can make.

If your goal is to avoid hassles with the IRS, obtain large business deductions, and provide a secure retirement for yourself in a short period of time, the 412(i) is worth looking into.

Lee Phillips has a detailed information piece on 412(i) that can be obtained by calling 800.806.1998.