Legal & Tax Trends A Publication of Business and Individual Planning December 2002 INSIDE THIS ISSUE: The Defined Benefit Pension Plan and 412i Page 2 Introduction Defined Benefit v. Defined Contribution Plan Page 5 412i Plan Page 11 Conclusion
Introduction The retirement plan market is commonly divided, at least conceptually, between large plans designed as employee benefits, and small plans designed as tax-sensitive savings strategies for business owner-dominated plans. In the employee benefit arena, current design trends have lead to the predominance of 401k plans (defined contribution), and renewed interest in defined benefit plans (in particular, cash balance plans). In the small plan market, where typically the principal plan participant is also a business owner, design trends have favored new comparability profit sharing plans (defined contribution) and the traditional defined benefit plan. We examined new comparability plans in a recent 1 ; here we consider the role of defined benefit plans, including the significance of 412(i) 2 in defined benefit plan design. Defined Benefit v. Defined Contribution Plan All tax-qualified retirement plans share the essential characteristic that employer contributions are currently deductible, while employee-participants recognize income only when they actually receive distributions from the plan. From the perspective of the business owner, this compares favorably to the nonqualified plan of deferred compensation in which the employer may fund the deferred compensation currently, but there is no deduction until the participant receives (or is in constructive receipt) of a distribution. The trade off for the tax advantages of the tax-qualified plan is that the qualified plan s benefits or contributions must not be discriminatory in favor of highly compensated employees. Moreover, the plan must be permanent, and contributions and benefits are limited to statutory maximums (indexed for inflation), and depending on the plan design, minimum contributions may be required. Maximum deductible contributions The simplest tax-qualified plan design is the profit sharing plan. The profit sharing plan is a defined contribution plan, and the simplest design would provide for the allocation of employer contributions as a level percentage of compensation to each participant s account, which is deemed to be nondiscriminatory in favor of highly-compensated employees. 3 Although a profit sharing plan must be intended to be permanent to be tax-qualified, the amount of employer contribution in any single plan year is discretionary, and may be skipped altogether. From the business owner s perspective, the profit sharing plan has the advantages of simplicity in allocation, and flexibility of permitting a substantial contribution or no contribution in any particular plan year. The maximum annual business deduction for profit sharing plan contributions is 25% of compensation of covered employees. 4 However, the maximum annual plan allocation on behalf of each individual participant in a defined contribution plan, including the profit sharing plan, is the lesser of the participant s compensation or $40,000. 5 Depending on the relative ages and compensation of the owner-employee and other plan participants, the owner-employee may be able to enhance the efficiency of the allocation of plan contributions to provide for his own retirement with an allocation formula which takes participant age into account, either directly through an age-weighted allocation, or indirectly by relying on cross-testing 6 of selective level allocation rates to demonstrate nondiscrimination (new comparability). Regardless of how efficient the profit sharing plan allocation may be in allocating the maximum contribution to the owner-employee at the lowest cost for allocations to other participants, the owner-employee will still be limited to the defined contribution maximum, currently $40,000. At retirement, the owner-employee will have a retirement benefit equal Page 2
to whatever account balance will accumulate on the annual plan contributions. If the owner-employee is age 45 or older at the time contributions are begun, the ultimate benefit (account balance) may be insufficient in retirement. Assuming the business can support a more substantial plan contribution level, the owner-employee may consider establishing a defined benefit pension plan. Unlike defined contribution plans like the profit sharing plan for which annual participant contributions are limited, the defined benefit plan is limited with respect to the maximum annual benefit which the plan can provide at retirement. The current maximum defined benefit which a tax-qualified plan can provide is $160,000 7 of annual income for a retiree s lifetime, commencing at age 62. The annual deductible employer contribution to a defined benefit plan is determined primarily by what annual funding will be necessary to fund the benefit at retirement. The determination of the limit of deductible contributions to a defined benefit plan is a function of the benefit formula, including age and compensation of participants, and reasonable assumptions regarding salary inflation, investment earnings, mortality, etc. Table 1 Entry Annual Age ILP 43 $44,573 44 49,004 45 54,024 46 59,742 47 66,302 48 73,883 49 82,723 50 93,138 51 105,559 52 120,588 The level of contribution attributable to each year is also affected by the actuarial method for allocating costs over the working careers of participants. In order to compare the effectiveness of the defined benefit plan to the profit sharing plan to achieve maximum tax savings for an owner-employee, consider the example of a sole proprietor who will establish a maximum defined benefit plan. In order to consider a simple example (and to facilitate other comparisons below), assume that the plan s benefit formula will provide the single participant with a $160,000 annual lifetime income commencing at age 62. Further assume that the plan fund will earn 7%, there is no pre-retirement mortality, and there is no salary scale or inflation so that the maximum benefit is unchanged. 8 Based upon the Individual Level Premium actuarial method, the cost of the plan will be allocated to plan years as a level dollar amount sufficient to fund the benefit at retirement ----- age 62. By reference to Table 1, even for an owner-employee creating the plan as early as age 43, the funding exceeds the $40,000 limit on profit sharing plans. For an owner-employee entering the plan at age 52, the funding requirement is more than triple the maximum profit sharing limit. From Chart 1, the owner-employee will accumulate sufficient assets in the plan to fund the maximum defined benefit at age 62 (approximately $1.8 million) regardless of entry date. Had the owner-employee entering the plan at age 43 created a profit sharing plan instead, he would have accumulated almost as much value (approximately $1.6 million) in the plan as under the defined benefit plan. But the owner-employee who created a profit sharing plan rather than a defined benefit plan at age 52 would have accumulated only $600,000 instead of $1.8 million under the defined benefit plan. Page 3
$1,800,000 $1,600,000 $1,400,000 $1,200,000 $1,000,000 $800,000 $600,000 $400,000 $200,000 $0 Chart 1 Accumulated Fund (Year End) "Defined Benefit" "Defined Contribution" Entry age 43 Entry age 52 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 Age An owner-employee could create a defined benefit plan later than age 52, the latest entry age illustrated, but additional limitations would have to be taken into account. The 415 maximum benefit can be payable as early as age 62 without adjustment, however a participant cannot fully accrue the dollar maximum ($160,000) under 415 with less than ten years of participation in the plan. At entry age 52, the owner-employee will have ten years of participation at age 62, and be able to take full advantage of the maximum benefit under 415. If he entered the plan later, the earliest retirement age to take advantage of the full limit would be ten years after entry. The above illustration is based on the Individual Level Premium funding method; there are other actuarial methods which would provide greater flexibility in allocating plan costs to future years. Notwithstanding the flexibility that results from choosing funding methods and assumptions, funding is required under 412, and failure to make a minimum contribution will subject the employer to penalties in addition to the funding requirement. This funding obligation is in contrast to the discretionary funding of a profit sharing plan. 9 Pre-retirement death benefits Insurance A defined benefit plan can provide a pre-retirement death benefit in addition to the defined retirement benefit. It is required of all tax-qualified retirement plans that such death benefit protection must be incidental to the primary purpose of providing retirement benefits. A pre-retirement death benefit is incidental in a defined benefit plan if the death benefit does not exceed 100 times the projected monthly retirement benefit. 10 For example, if the projected annual retirement benefit is the 415 maximum of $160,000 annually, the maximum monthly benefit is $160,000 12 = $13,333. Therefore the maximum death benefit protection would be $1.3 million. Alternatively, the pre-retirement death benefit may be defined in terms of the death benefit which may be supported by not more than 50% of the employer contribution credited to each participant s account. 11 This contributionbased rule applied in the defined benefit plan context may provide even greater preretirement death benefits than the 100 times rule. In either case, significant pre-retirement death benefits can be funded through the purchase of insurance by the plan. The cost or premium would add to the required funding of the plan, and thereby increase the employer s total deductible contribution. If the insurance contract is projected to have cash value at retirement, the cash value will be available to partially fund the retirement benefit. Thus the addition of a pre-retirement death benefit will increase the net funding required to support the plan, though not by the full amount of the insurance premium. Page 4
In defined contribution plans (which includes profit sharing plans), the incidental benefit rule customarily applied to pre-retirement death benefits is a limit on the permissible premium rather than the death benefit, i.e., not more than 25% of aggregate employer contributions for life insurance premiums generally, or not more than 50% of aggregate employer contributions for a traditional whole life policy. In contrast to the defined benefit plan, the addition of a pre-retirement death benefit to a defined contribution plan can be funded only from contributions within the 415 annual addition limitation. 12 The limitation is not increased by virtue of the addition of the pre-retirement death benefit, so that the cost of death benefit protection will lower the ultimate account accumulation, without increasing the opportunity to make deductible contributions to the profit sharing plan. Combinations of Plans The fact that an employer sponsors a defined benefit plan would not prevent the employer from also maintaining a defined contribution plan such as a profit sharing plan. Formerly, employees who participated in both types of plans were not able to fully benefit from both plans under complicated combined plan limitation provisions. The combined plan limitation was eliminated at the participant level for plan years after 1999. 13 Consequently, the same participant can receive a full maximum annual addition to his defined contribution account without affecting his participation in a defined benefit plan. However, there remains an overall deduction limitation on the employer plan sponsor of not more than 25% of payroll where, for example, a profit sharing plan is maintained in addition to a defined benefit plan. If in fact the required contribution to the defined benefit plan exceeded 25% of payroll with respect to a plan year, the employer could deduct the required contribution to the defined benefit plan, but no deductible contribution could be made to the profit sharing plan. In the small closely held employer situations, where the defined benefit plan is designed to provide maximum benefits for the owner-participants, the required defined benefit contribution will typically exceed 25%, making the addition of a profit sharing plan impossible. The Economic Growth and Tax Relief Reconciliation Act of 2001 14 ( EGTRRA ) has mitigated this situation somewhat, effective for plan years beginning after 2001, by providing that elective deferrals will no longer count as employer contributions for purposes of the 25% of payroll limit on employer deductions. 15 The result is that an employer can add a 401k plan (technically a profit sharing plan with an elective deferral feature) which provides for elective deferrals only. Since elective deferrals do not count toward the 25% of payroll limitation on employer contribution deductions, the employer will be able to fully deduct any elective deferrals to the 401k plan, in addition to required contributions to the defined benefit plan, without violating the deduction limitations of 404 for the combination of defined benefit plan and 401k plan. Thus, in addition to the defined benefit plan contributions indicated above, elective deferrals for 2003 could add $12,000 in annual additions on behalf of an owner-employee, plus $2,000 in makeup deferrals if the owner-employee was at least age 50. 412i Plan The quest for even greater employer deductions than those indicated above for a maximum benefit defined benefit plan has led to renewed interest in subsection (i) of 412 which prescribes funding of the defined benefit pension plan. A defined benefit pension plan which complies (or is intended to comply) with the requirements of 412(i) is referred to as a 412i plan. However, 412i is not a plan but rather a funding strategy for an otherwise ordinary defined benefit pension plan. This funding strategy can lead to higher deductible Page 5
contributions at least initially compared to the more customary actuarial funding methods permitted under 412. Section 412 requires that, with respect to a tax-qualified retirement plan, the employer must maintain a funding standard account for the plan, and the employer must make sufficient contributions annually to avoid having an accumulated funding deficiency in the account. 16 The funding standard account is the basic actuarial model of plan liability on which the deductibility of employer contributions is based, and it requires the professional services of an actuary to provide analysis and necessary reporting. 17 The employer s obligation to fund the pension plan is subject to a range of maximum and minimum annual contributions, depending on the actuarial funding method, and there are excise taxes for overcontributing, 18 and for under-contributing. 19 There are, however, several notable exceptions to the funding requirements of 412. In particular, 412(h) provides that an insurance contract plan described in 412(i) is exempt from the general provisions of 412. 20 An insurance contract plan is a defined benefit pension plan which is funded exclusively through individual insurance and annuity contracts. Exclusive funding of a participant s plan benefit through the insured contracts (individual annuity and insurance) means that benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age. Since values under annuity and life insurance contracts are guaranteed or insured only to the extent premiums are paid, compliance with 412(i) requires that all premiums are paid and that there are no loans or other security interests against the policies. The contracts must provide for level annual premium payments, with the premium paying period beginning with each individual s participation in the plan and ending at normal retirement. Table 2 Entry Annual 412i Age ILP Premium 43 $44,573 $98,191 44 49,004 105,331 45 54,024 113,331 46 59,742 122,353 47 66,302 132,602 48 73,883 144,341 49 82,723 157,913 50 93,138 173,778 51 105,559 192,559 52 120,588 215,133 Because a 412i plan is funded exclusively with individual annuity contracts with level annual premium payments from entry into the plan to retirement, the pattern of funding would look very similar to a plan using the Individual Level Premium actuarial method described in the defined benefit plan example above if the funding interest rate were the same. The difference, however, and the principal perceived advantage of 412(i), is that the funding level under 412(i) is based upon the guaranteed return on which the premiums are based. For example, if the individual level premium for the annuity is based upon the insurer s guaranteed return of 3%, then in effect the 412i plan premium - and therefore the deduction for funding - is based upon 3%, at least initially. Table 2 illustrates the difference in initial deductible plan contributions for different entry ages for a maximum defined benefit plan. Clearly the premiums for the 412i plan, and consequently the contribution deductions, are substantially increased. 21 The increase is only in the expected plan contributions, however. A 412i plan is subject to the same retirement benefit and pre-tax death benefit limitations which apply to all defined benefit pension plans. Regardless of how much it appears to cost to fund the benefits under 412(i), the plan can only provide the 415 maximum benefit at age 62, which could be paid as a lump sum only on the basis of actuarial assumptions prescribed by the IRS. Page 6
In addition, because a fully-insured plan is exempt from the provisions of 412(i), such a plan is exempt from the specific funding and reporting requirements of 412 22 so that no Schedule B is required with the Plan s annual Form 5500 report, and the services of an Enrolled Actuary would appear to be unnecessary. Further, since the benefits are fully insured, the 412i plan pays only the fixed portion of the PBGC premium ($19 per participant in 2002); the variable portion is $0. 23 Problems of 412i Plans The problems inherent in complying with 412(i) are more apparent from the nondiscrimination regulations under 401(a)(4). As a tax-qualified retirement plan, the 412i plan must satisfy the basic requirement that the plan is not discriminatory in favor of highly compensated employees. Accordingly, the nondiscrimination regulations are a source of additional important limitations for insured plans, which must be nondiscriminatory as well as satisfy the conditions of 412(i). Thus, an insured plan must also satisfy the following conditions: 24 1. The plan must satisfy the accrual rule of 411(b)(1)(F). This condition with respect to accrual during a participant s career is in addition to the 412(i) conditions that the benefit must be funded exclusively with guaranteed annuity and life insurance contracts which require level annual premiums, and that the plan benefit is equal to the contract benefit at retirement. In effect, this accrual rule requires in addition that the employee s accrued benefit at any time prior to retirement is not less than the cash surrender value of the annuity and insurance contracts funding the participant s benefit (assuming all premiums were paid and there were no loans or security interests against the policy). This condition makes variable annuity and variable life insurance contracts unsuitable for funding a 412i plan. It also eliminates the possibility of funding such a plan solely with insurance contracts, since the cash value would not correspond to benefit accrual under a retirement plan formula. 2. The benefit formula may not recognize past service. The benefit formula under the 412i plan (not merely the pattern of benefit accrual) must be one that would satisfy the requirements of the fractional accrual rule. The fractional accrual rule requires that a participant s normal retirement benefit must accrue pro rata or ratably over the participant s period of service through normal retirement age. However, under a 412i plan the normal retirement benefit formula must accrue ratably over the participant s period of plan participation through normal retirement age. Essentially, the benefit formula must be based on years of participation in the plan rather than years of service with the employer. The difference can be illustrated with a simple example; assume a 412i plan is established when the owner-employee is age 52. The largest benefit and deduction could be achieved ($160,000 at age 62) with a benefit formula of 8%/year of participation, which would result in: 10 years participation at age 62 x 8% = 80% 80% of final average compensation, assuming maximum compensation of $200,000 results in the maximum pension benefit of 80% x $200,000 = $160,000. The same 8%/year of participation must be applied to every other participant as well. Assume, however, that in creating the plan the formula was based on service with the employer, and up to five years of past service was taken into consideration. 25 Typically the owner-employee would have considerable service in the business before the business is able to sustain a substantial defined benefit pension plan. Assuming the owner-employee had Page 7
five years of service prior to establishing the plan, the formula could provide for 5 1 / 3 % for each year of service. The owner-employee would have 15 years of service at retirement (entry at age 52 to retirement at age 62, plus 5 years of prior service), and the normal retirement benefit would be 5 1 / 3 % x 15 years = 80% of $200,000. Under this formula only the 5 1 / 3 %/year must be applied to every other participant. Since participants other than the owner-employee are less likely to have prior service, this formula would likely be less expensive on a plan basis, and it would be a permissible way to design a formula in an ordinary defined benefit plan. The nondiscrimination requirement prevents a 412i plan formula from recognizing years of service before an employee commenced participation in the plan. 3. The scheduled premium paying period is entry date to retirement date. The scheduled premium payments under an individual or group insurance contract used to fund an employee s normal retirement benefit must be level annual payments to normal retirement age. Thus, payments may not be scheduled to cease before normal retirement age. The 412(i) requirements had only required that the premium paying period not extend beyond normal retirement age, but presumably any shorter period would comply. But the nondiscrimination regulations specifically require 412i plans to schedule level annual premiums over the participant s career. 4. Experience gains, dividends, forfeitures, and similar items must be used solely to reduce future premiums. Level annual premiums for guaranteed annuity and life insurance contracts are based on conservative assumptions, e.g. 3% interest for internal cash value. The excess return earned by the insurer is distributed to policyholders through dividends. Forfeitures would result from participants terminating employment prior to vesting under the pension plan provisions. Such returns to the plan in excess of the guaranteed rate underlying the determination of premiums must be applied to reduce future premiums, and therefore, future deductible plan contributions. Since competitive annuity and life insurance products can reasonably be expected to outperform their underlying guaranteed rates, the result is that, unless the pension plan provisions are changed, plan funding will be front-loaded for early plan years, rather than level over the period of an employee s participation. $100,000 $90,000 $80,000 $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 ILP 412i Chart 2 Contributions 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 Page 8 Age For the sake of comparison of the ordinary ILP funding illustrated above to 412i, assume that the ILP-funded plan uses an 7% funding assumption as first assumed above, and that the 412i plan purchases individual annuity contracts with a guaranteed return of 3%. The contributions under the 412i plan will be higher if the contracts really performed at the 3% level, but assuming the return is not compromised by funding through the annuity contract, the
dividend rate under the contract would be 4%, so that the total return would be 7%. Since this excess return of 4% must be applied to reduce future contributions under 412i, the pattern of future contributions will decline as illustrated in Chart 2 for the 43 year-old entrant with a maximum defined benefit at age 62. The net result of the 412i funding method therefore is to front load the employer s deductions for the plan. Assuming the continued performance of the individual annuity contracts at 7%, it is clear that the plan will become overfunded, at least with respect to the maximum benefit available as a lump sum at 62. As Chart 3 illustrates, normal funding under the ILP method takes the 7% return into account in establishing the level annual contribution, and the plan fund accumulates to the lump sum value of the retirement benefit at age 62. As long as the plan accumulation rate is not less than the 415 lump sum rate prescribed by the IRS, the plan benefit will not overfund the maximum 415 benefit payable as a lump sum at age 62. However, under 412(i), the contribution level is based initially on the 3% guaranteed return. The higher contributions determined at 3% are reduced almost to $0 by the 4% excess return under the contracts (see Chart 2). But assuming the contracts continue to perform at the total 7% rate, the plan fund will nevertheless accumulate to an amount in excess of the lump sum value of the maximum retirement benefit, i.e., the age 62 retirement benefit payable as a lump sum would be over-funded. If the excess funding reverts to the employer, the employer will pay a nondeductible excise tax 26 of up to 50% in addition to income tax, which will essentially eliminate the excess. Possibly the annuity contracts will avoid over-funding the plan by failing to $2,500,000 perform as well as the investments $2,000,000 under the non-412i plan, which is hardly an $1,500,000 advantage. Alternatively, at some point in the $1,000,000 life of the 412i plan, the employer will $500,000 have to abandon 412(i) and resort to a more $0 traditional actuarial funding method to avoid overfunding the benefit. Chart 3 Accumulated Fund (Year End) 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 5. All benefits must be funded through contracts of the same series. Among other requirements, contracts of the same series must have cash values based on the same terms (including interest and mortality assumptions) and the same conversion rights. This requirement becomes a consideration for a plan that is designed to take advantage of the incidental benefit rules to provide substantial pre-retirement death benefits in addition to retirement benefits. The death benefit would be provided through plan-owned life insurance policies. At retirement, the cash value of such policies would be available to fund the retirement benefit, and therefore the life insurance contracts interact with the annuity contract funding to reduce somewhat the amount of funding through the annuity contract necessary to accumulate the value of the benefit at retirement. The regulation requires that Age 412i 415 ILP Page 9
life and annuity contracts used in combination to fund the 412i plan must be based on the same mortality and interest assumptions so that the equivalence of benefit with cash value will be maintained at every age. Top-heavy 412i plans In addition to the special 412i plan requirements under the 412 regulations and the 401(a)(4) nondiscrimination regulations, there are the special issues that arise for 412i plans from other qualified plan requirements that apply generally but create special problems for 412i plans. In particular, the top-heavy requirements of - 416 create a special challenge for 412i plans. A defined benefit plan is top heavy if more than 60% of the present value of accrued benefits under the plan are attributable to key employees. Key employees include; (1) employees who own more than 5% of the employer, (2) employees who own more than 1% of the employer and whose compensation exceeds $150,000, and (3) officers whose compensation exceeds $130,000. 27 One consequence of being top-heavy, and the principal consequence for 412i plans, is that the plan must provide that in any year during which the plan is top-heavy, non-key employees must accrue a minimum 2% of compensation, payable as a single life annuity beginning at normal retirement age. The minimum accrual is subject to a maximum 20%, so that a plan that has been top heavy for 10 years must provide a minimum accrued benefit of 2% 10 years = 20% of compensation at retirement. 28 But recalling the requirement under the nondiscrimination regulations, noted above, that the cash value under each participant s individual annuity contract must be not less than his accrued benefit, the minimum top heavy accrual requirement is problematic for a 412i plan. In early policy years under the usual individual annuity contract, the cash value will not increase by an amount equal to the minimum 2% benefit accrual. Premiums cannot be increased with respect to early years to improve cash value, since premiums must be level over the participant s service to retirement. In the case of an owner-dominated defined benefit plan which is a typical situation for 412i plans, the plan is likely to be top-heavy. In order to provide the minimum top-heavy 2% accrual, the plan will have to provide for supplemental benefit accrual (and supplemental funding) in addition to the individual annuities funding the plan. The regulations under 416 do provide specifically for top-heavy 412i 29 plans that: (1) the targeted normal retirement benefit under the insurance contract must take into account the defined benefit minimum that would be required, assuming the top-heavy (or non-topheavy) status of the plan continues until normal retirement age; and (2) the benefits provided by the auxiliary fund or deferred annuity contracts must not exceed the excess of the defined benefit minimum benefit over the benefit provided by the level premium insurance contract. If both conditions are met, the portion of the plan funded by the level premium annuity contracts will continue to be exempt from the 412 minimum funding requirements. However, the part of the plan funded with the auxiliary fund or deferred contracts will be subject to the 412 minimum funding rules (and, thus, the plan must set up a funding standard account and file a Schedule B to IRS Form 5500 with respect to this portion of the plan). Further, the accrued benefit for any participant may be determined under 411(b)(1)(F) but must not be less than the defined benefit minimum. The residual benefit for a top-heavy 412i plan is that the non-top-heavy portion of the plan continues to be funded with the conservative guaranteed interest assumption, but in every other respect the top-heavy 412i plan will be funded and administered like any other defined benefit plan. Page 10
Conclusion The optimum design of a retirement plan for a small business will normally take into account the typical circumstance that the owner or owners are usually somewhat older than the other employees. This difference in age can be exploited in a defined contribution plan by allocating contributions to the advantage of the owners and relying on cross-testing of the resulting allocation rates as benefit accrual rates. The defined contribution plan may be effective for this purpose as long as the owner or owners are satisfied with the defined contribution maximum annual allocation ($40,000 in 2003). If the employer is able to commit to making significantly greater annual contributions to a retirement plan, the defined benefit plan may provide the opportunity to shelter much greater annual contributions. However, the defined benefit plan creates an obligation to meet the funding requirements into the future, unlike the profit sharing defined contribution plan under which annual contributions are discretionary. Greater contributions can be justified and deducted with respect to a defined benefit plan if the business owner is willing to accept the inflexible design requirements of 412(i). The benefits must be funded exclusively with fixed level premium annuity and insurance contracts. The increase in deductible contributions is the result of the conservative assumptions inherent in the fixed annuity and insurance contracts. If the contracts do in fact perform in accordance with the low guaranteed return implicit in setting the premiums, the plan will be genuinely more expensive, although the business owner may prefer the fact that funding at that conservative rate of return was guaranteed. If in fact the contracts perform more or less comparably to investments otherwise available to retirement plans, the excess return will reduce future contributions (other factors remaining constant), and the business owner will achieve increased deductible contributions only initially in funding the plan; the plan contributions and deductions will be front-loaded compared to more typical funding methods. The 412i plan does not increase the retirement and pre-retirement death benefits otherwise available under defined benefit plans. In addition, if the plan becomes top-heavy, the funding and administration of the plan will become more complicated, largely eliminating the advantages, real or imagined, in using 412(i) to fund the plan. While funding may still be based on the conservative guaranteed return for benefits guaranteed under the fixed annuity contracts, in all other respects the plan must be funded and administered like non-412i defined benefit plans. (Footnotes) 1, Vol. 9, Issue 2, 2002, New Comparability - The Evolution of Profit Sharing Plan Design. 2 Internal Revenue Code ( IRC ), 412(i). 3 IRS Reg. 1.401(a)(4)-2(b)(2). 4 404(a)(7)(A). 5 415(c). 6 IRS Reg. 1.401(a)(4)-8. 7 The lesser of $160,000 or 100% of the participant s three-year average compensation, 415(b) 8 Assume post-retirement mortality according to the Group Annuity Reserve 1994 table. At 7% investment earnings, the value at age 62 of a single life annuity providing $160,000 annually is approximately $1.8 million. 9 412(h). 10 Rev. Rul. 68-453; pre-retirement death benefit may not exceed the greater of (a) the proceeds of ordinary life insurance policies providing a death benefit of 100 times the anticipated monthly normal retirement benefit or (b) the sum of (i) the reserve under the ordinary life insurance policies plus (ii) the participant s account in the auxiliary fund. Page 11
(Footnotes continued) 11 Rev. Rul. 74-307; death benefits under a pension plan of any type will be considered incidental if either (1) less than 50 percent of the employer contribution credited to each participant s account is used to purchase ordinary life insurance policies on the participant s life, even if the total death benefit consists of both the face amount of the policies and the amount credited to the participant s account at the time of death, or (2) such death benefits would be considered incidental under Rev. Rul. 68-453 12 The rule is somewhat more liberal for profit sharing plans which may provide that seasoned contributions (more than 2 years in the plan) are not restricted by the incidental rule. See, Vol. 9, Issue 2, 2002. 13 Small Business Jobs Protection Act of 1996. 14 Public Law 107-16. 15 EGTRRA 614, adding IRC 404(n) to provide, effective January 1, 2002: Elective deferrals not taken into account for purposes of deduction limits Elective deferrals (as defined in section 402(g)(3)) shall not be subject to any [employer deduction] limitation contained in paragraph (3)[defined contribution 25% of payroll limit], (7)[combined defined contribution/defined benefit plans], or (9)[limit for ESOP s] of subsection (a) or paragraph (1)(C) of subsection (h)[25% limit for SEP s], and such elective deferrals shall not be taken into account in applying any such limitation to any other contributions. 16 IRC 412(a)(2), (c)(11), and Employer contributions to fund the pension plan are deductible to the employer, IRC 404(a)(1). 17 Annual Report, Form 5500, Schedule B, Actuarial Information. 18 10% of the non-deductible contribution, 4972(a). 19 10% of the accumulated funding deficiency, 4971(a). 20 Profit sharing plans are also exempt from the 412 funding requirements, 412(h). 21 For simplicity, and to limit the comparison of contributions specifically to the difference of rates of return in funding, the premiums for the individual annuity are based on the same post retirement mortality assumptions as the ILP method above, with no loading of premiums for insurance company expenses, i.e., net premiums. An actual policy would introduce expense loading and other factors which complicate the comparison. 22 IRS Reg. 1.412(i)-1(a). 23 PBGC Reg. 4006.5(a) 24 IRS Reg. 1.401(a)(4)-3(b)(5). Rev. Proc. 2000-5 provides that: SECTION 8. OPINION LETTERS SCOPE ¼.03 Areas Not Covered by Opinion Letters Opinion letters will not be issued for: 17. Fully-insured section 412(i) plans, other than plans that, by their terms, satisfy the safe harbor for section 412(i) plans in section 1.401(a)(4)-3(b)(5). 25 The maximum amount of prior service which may be taken into consideration under the nondiscrimination safe harbor rule regarding prior service, IRS Reg. 1.401(a)(4)-5. 26 4980 27 416(i)(1)(A). Ten percent of employees shall be treated as officers, but not fewer than 3 (or as many employees as there are if fewer than 3), nor more than 50. The $150,000 compensation threshold is indexed after 2002. 28 416(c). Minimum vesting requirements are also accelerated for a top-heavy plan, 416(b). 29 IRS Reg. 1.416-1, Q&A M-17. is jointly published by the Business and Individual Planning attorneys of MetLife, GenAmerica Financial and New England Financial. The following individuals contribute to this publication: At MetLife: Lori Epstein, Jeffrey Hollander and Jeffrey Jenei; At GenAmerica Financial: Andrew Weinhaus, Thomas Barrett, Sonja Hayes and Benjamin Trujillo; At New England Financial: Stephen Chiumenti, Kenneth Cymbal, Stephen Houlihan, Margaret Muldoon, and Stacy Wolfe. The information provided is derived from sources believed to be accurate. This publication is not intended as legal advice; for this you should consult your attorney. L0301H1FH (exp0106) NEF-LD Page 12