412(i) plans continue to generate both interest and caution following recent Internal Revenue Service and Treasury Department actions to crack down on a handful of abusive schemes that had cropped up in this marketplace.
Unlike 401(k) and other defined-contribution plans, a defined-benefit 412(i) plan is not subject to the $41,000 contribution limit ($44,000 with catch-up salary deferrals). Contributors may deduct whatever the plan cost is calculated to be in order to fund the known benefit at retirement.
For example, a participant who earns $165,000 or more in salary, is age 55, and wants to retire at age 65, can deduct over $200,000 in a 412(i) plan.
In the target market, an S corporation election is very common. Because W-2 wages are subject to payroll tax and passive dividend income is not, most S corp owners take modest W-2 wages and prefer to pass through the majority of profit free of payroll tax. While this may make great tax planning sense, it dramatically curtails the retirement plan contribution, which is dependent on the W-2 wage alone.
Fortunately, a 412(i) or classic defined-benefit plan can leverage a modest W-2 wage for a mature participant into a stunning pension contribution that can easily exceed 100 percent of pay! For example, a W-2 wage of $50,000 would translate into a maximum SEP-IRA contribution of $12,000 for a 50-year-old, but will allow a 412(i) contribution of over $75,000.
412(i) plans are defined-benefit pension plans that use an insurance company's guaranteed rates and values to "fully insure" the predetermined future benefit. If the annuity and whole life insurance contracts funding the plan perform better than the minimum contractual guarantee, future plan costs decrease. Thus, a 412(i) plan can frontload the funding of the defined benefit and achieve higher initial tax deductions than most traditional defined-benefit plan designs.
By contrast, a classic defined-benefit plan invests its monies into a pension trust that is then managed by the plan's trustee.
A 412(i) plan is required to fund all of its benefits using certain insurance and annuity contracts. Because these plans are often nicknamed "fully insured" plans, some people forget that life insurance must be incidental to the plan. This fact was restated recently in Internal Revenue Service Ruling 2004-20, which essentially reiterates the two permissible methods to determine how much life insurance is allowable.
412(i) and classic defined-benefit plans have tremendous appeal for small, closely held businesses that are successful and have few, if any, employees. The initial tax-deductible contributions and projected benefits are unparalleled for participants age 40 and older. But care must be exercised to assure that a 412(i) or defined-benefit plan is properly designed and funded.
Lance Wallach, CLU, ChFC, CIMC, of Plainview, N.Y., speaks and writes extensively about VEBAs, pension plans and tax reduction strategies. For more information and additional articles on the subject, reach him at (516) 938-5007, or visit www.vebaplan.com.
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