Mention defined benefit plan to most employees and their reaction is, “Wouldn’t that be nice.” Defined benefit plans — where employers set aside money in a retirement plan that guarantees benefits after a certain number of years of service — have been in rapid decline for more than a decade.
Why? Ask employers: High cost, complex regulations and actuarial calculations, potential under-funding issues.
Pose the same question to a small business: “Totally out of the question” is the likely response. In actuality, a defined benefit plan may be one of the most accessible — and desirable — benefits for a small business (including a manufacturers’ representative agency) to consider.
That’s because deep in the Internal Revenue Code is a provision that makes it both cost-effective and highly advantageous — particularly from a tax-planning point of view — for a small-business owner to set up a defined benefit plan. The provision has actually been around since 1979, and it’s contained in section 412(i) of the IRS code, which is how these plans get their name.
A 412(i) plan is one of the least understood yet most effective tax-advantaged savings instruments available to a small-business owner. The beauty of these plans is that they provide all the positives of a traditional defined benefit plan but with fewer of the complicated reporting requirements or the investment risks of a traditional plan. Good candidates for such plans include manufacturers’ representatives.
How Do the Plans Work?
Traditional defined benefit plans generally are funded by a sophisticated mix of investments. A 412(i) plan vastly simplifies this process through the use of insurance products — whole life insurance and annuity contracts — as the funding mechanism.
“In a 412(i) plan, the insurance company accepts the risk of earning too little and living too long,” explains Mark Zingle, president of Zingle and Associates, a Minneapolis fee-based specialist in 412(i) plan design. “The use of life insurance and annuities to fund the plan eliminates the need to construct a portfolio using various assets,” he continues.
Higher Contributions/Deductions
The 412(i) plan can provide many clients with higher deductions and contributions than virtually any other qualified retirement plan, combined with the highest benefits allowed in a qualified retirement plan. What follows shows the maximum contributions allowed for four older business owners in three types of qualified retirement plans. The 412(i) plan contribution is significantly higher in all cases. And for the 60-year-old, the 412(i) plan contribution is $330,000 higher than the contribution allowed in a profit‑sharing plan.
Examples of maximum contributions and plan comparisons, by age:
- A 45-year-old who plans to retire at age 62 would be able to invest a maximum of $42,000 in a traditional profit-sharing plan, $87,727 in a traditional defined benefit plan and $167,518 in a 412(i) plan.
- A 50-year-old who plans to retire at age 62 would be able to invest a maximum of $46,000 in a traditional profit-sharing plan, $146,310 in a traditional defined benefit plan and $265,187 in a 412(i) plan.
- A 55-year-old who plans to retire at age 62 would be able to invest a maximum of $46,000 in a traditional profit-sharing plan, $212,155 in a traditional defined benefit plan and $367,031 in a 412(i) plan.
- A 60-year-old who plans to retire at age 65 would be able to invest a maximum of $46,000 in a traditional profit-sharing plan, $221,589 in a traditional defined benefit plan and $375,781 in a 412(i) plan.
Tax considerations are an important consideration for all qualified retirement plans. Within limits, all contributions to a qualified retirement plan are tax exempt, and an important difference between a traditional defined benefit plan and a 412(i) is that because insurance is used to fund the plan, a small-business owner can contribute considerably more money to a 412(i) plan than a conventional plan, generating a much higher deduction.
This allowance involves several key assumptions concerning the structure of the insurance products used to fund the plan. Because of that, it’s also important that the type of insurance and the way the policies or annuity contracts are structured be closely examined by your financial advisor to make sure the plan steers clear of some recent concerns raised by the IRS about these plans.
