412(i) Plan
A defined benefit pension plan promises either a stated benefit amount at retirement or provides a benefit which is determined according to a fixed formula. The employer bears the responsibility of providing funding that will provide the benefit promised by the plan, based on actuarial assumptions. Investment performance must be closely monitored and projections made so the employer knows how much to contribute to provide the retirement benefits promised under the plan. Typically, a pension actuary tells the employer how much to contribute annually, and a plan administrator is in charge of the administrative details of the plan. Businesses that use defined benefit pension plans are often smaller firms with older, higher paid employees who are owners or shareholders. The reason defined benefit plans appeal to these firms is because the benefit formula can be based on recent compensation levels and/or years of service, which will tend to favor owners and managers. If there is not much time to build a substantial retirement fund for key employees (including owners) and the company has the financial ability to fund the plan, a defined benefit plan is often a good choice. There are limits to the benefit amounts that can be provided under a defined benefit plan. The highest annual benefit that can be paid for any limitation year ending in 2003 is the lesser of: - 100% of the participant's average compensation for the three highest consecutive calendar years during which the employee was an active participant under the plan, or
- $160,000.
The dollar limitation is indexed to inflation in $5,000 increments, rounded down to the next lowest multiple of $5,000. In order to obtain the full maximum benefit, 10 years of participation is required. Only the first $200,000 for 2003 of an employee's annual compensation may be taken into account in determining benefits. A combination of statutory changes and regulatory and compliance burdens made defined benefit plans lose popularity in the 1980s and 1990s. Some of these regulatory problems related to the intricacies of the Internal Revenue Code's "minimum funding rules." If the funding rules were the problem, then a plan that was exempt from the minimum funding rules could be the answer. A defined benefit pension plan that meets the requirements of Section 412(i) is such a plan. A Section 412(i) plan is generally a defined benefit pension plan in which: - Plan benefits are funded entirely by individual annuity and life insurance contracts issued by an insurance company (i.e., a fully insured plan);
- The contracts must provide for level annual premiums that begin when an employee becomes a plan participant and end no later than the employee's retirement age under the plan;
- The plan benefits must be equal to the benefits provided under each contract at the plan's normal retirement age, and must be guaranteed by an insurance company to the extent premiums have been paid;
- All premiums due on these contracts are paid for the current plan year and for all prior plan years;
- Rights under these contracts are not subject to a security interest at any time during the plan year; and
- No policy loans against these contracts are outstanding at any time during the plan year.
Some of the reasons Section 412(i) plans are attractive are the following: - There is no full funding limitation or current liability test to limit the employer's deduction, thus making larger contribution deductions possible;
- Due to the low interest rates allowed in 412(i) plans, the contributions (and, therefore, tax deductions) available for older owner-employees can be significantly higher;
- With increased funding, larger benefit payouts are likely at retirement;
- If death occurs before retirement, a portion of the beneficiaries' death benefit is income tax-free rather than fully taxable as is the account value typical in other retirement plans;
- Individuals whose personal portfolios and defined contribution accounts were hurt by the general market downturn in 2000-2002 may find the guaranteed values and safety of principal in a 412(i) plan attractive;
- The IRC Section 415 limit on defined benefit plans is no longer reduced for persons retiring between age 62 and 65; and
- Plan assumptions are not subject to attack, since they coincide with the guarantees in the contracts.
Other considerations with respect to Section 412(i) plan include: - All plan assets must be held by an insurance company;
- The plan cannot allow loans;
- If a bull stock market returns, a 412(i) plan will not participate in the growth of equity values, and defined contribution plans may regain the favor they enjoyed in the 1990s;
- a 412(i) plan may have limited appeal outside small and/or family corporations, where large
- allocations can be made to the accrued benefits of the owner(s); and
- The IRS has informally raised concerns about certain 412(i) plans that require a limited number of premium payments, and are terminated after a few years with the contracts being rolled out to employees at a time when cash values are low. Issuing guidance on 412(i) plans is believed to be high on the IRS's agenda.
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