Article: 412(i) as an Alternative to Your 401(k)

June 2005

412(i) as an alternative to your 401(k)

Advantages include larger tax deductible contributions, lower administrative costs, predictable contributions, no worries about over- or underfunding the plan, and guaranteed retirement benefits

For small business owners, retirement planning in today's financial climate poses several challenges. Despite recent gains in the equity markets, the past few years’ fluctuations in your company’s 401(k) and profit-sharing plans and stock market investments have probably caused you more than a little concern over what the value of those plans will be at any point.

If your planning priorities include maximizing your future retirement income, minimizing your current income taxes, and having adequate life insurance protection, a 412(i) plan may be appropriate for your business.

Advantages. A 412(i) plan may provide you with larger tax deductible contributions than other qualified retirement plans, less administrative expense, predictable contributions, no worries about over- or underfunding the plan, and guaranteed retirement benefits.

A 412(i) plan invests solely in life insurance and annuities and has a guaranteed rate of return. It is exempt from the IRC Sec. 412 minimum funding requirements, making it relatively inexpensive to administer. Since 412(i) plans use lower interest rate calculations than traditional defined benefit plans, the employer can contribute larger tax-deductible amounts. On average, contributions to a 412(i) plan are up to three times greater than a traditional defined benefit plan and up to six times greater than a defined contribution plan. Also, since the benefits are guaranteed, a 412(i) plan can help shield participants from the volatility of the stock market.

The main difference between a 412(i) plan and a traditional defined benefit plan is the way benefits are calculated. With a traditional defined benefit plan, the plan benefit is determined using actuarial assumptions, which typically assume a higher interest rate (currently around 5% to 5.5%) than the minimum guaranteed rate of a 412(i) plan (currently around 2% to 4%). As a result of this difference, 412(i) plans allow employers to make larger deductible contributions and also provide plan participants with guaranteed retirement benefits.

Employers may contribute to both a defined contribution plan and a 412(i) plan in the same year, but the contributions to only one of the plans is deductible. The one exception to this rule is a 401(k) plan with no company contributions – i.e., only employee wage deferrals – made to it.

Employer contributions to a 412(i) plan will decrease each year when actual interest earned on the underlying insurance contracts exceeds the guaranteed interest. In this scenario, contributions are decreased and the excess interest income is applied to the contributions to the plan.

Options. Plan participants have several options as to how to receive retirement benefits. Generally, upon retirement, the participant must either surrender or buy the life insurance policy from the plan. They can then:

surrender the policy and then rollover the cash value;
purchase the policy at fair market value;
annuitize the policy; or
take a reduced paid-up policy.

Qualifying companies. To qualify for a 412(i), your business must meet the following criteria:

It must be a sole proprietorship, partnership, LLC, S corporation, or C corporation.
The owner or key employees are older than 45.
The other employees, if any, are younger and earn less than the owner or key employees.
The company is in sound financial condition with relatively certain future earnings.

If you meet the above criteria and would like to know more about a 412(i) retirement plan, contact your Schmidt Westergard & Company professional.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.