• An Alternative Retirement Option for the Wealthy
  • September 1, 2010
  • Law Firm: Doyle Golde Grossman Family Law Group - Danville Office
  • An Alternative Retirement Option for Wealthy Small Business Owners: IRC § 412(e)(3) Plans

        Internal Revenue Code Section 412(e)(3) Plans (formerly known as 412(i) Plans) can be an appropriate alternative retirement vehicle for certain wealthy small business owners.  A 412(e)(3) Plan is a defined benefit plan which is funded with annuities or a combination of annuities and whole life insurance.  The primary difference of 412(e)(3) plans and traditional defined benefit plans is that they are capable of creating larger tax-deductible contributions for the plan sponsor, the employer.

    The Mechanics of 412(e)(3) Plans.

        A 412(e)(3) Plan is a defined benefit plan funded with either annuities or life insurance and annuities.  The corporation purchases the life insurance and annuities and is entitled to a deduction for this payment.  The employee plan participant is not currently taxed on the receipt of the annuities and life insurance and the plan values will grow tax-deferred.  The employee plan participant will have to pay ordinary income tax once the employee begins receiving distributions from the plan upon reaching retirement age.  The retirement income to the employee is guaranteed by the annuities and life insurance and will not increase or decrease with the market.

    The Benefits of 412(e)(3) Plans.

        412(e)(3) Plans offer  larger tax-deductible contributions for the employer than other deferred compensation plans which increase the ability of the corporation and highly compensated employees from currently recognizing tax.  The large contributions result because the plans are premised upon the guarantees of the annuities and life insurance which have low assumed rates of return so the amount the employer is required to contribute is large. In addition to allowing for the deferral of large amounts of income, 412(e)(3) Plans are simple to administrate post set-up and an actuary is not needed for annual valuation or certification.

    The Negatives of 412(e)(3) Plans.

        Sound investing should focus on the growth of deferred compensation plans rather than simply the amount that can be deducted.  No net economic benefit is received if the plan allows larger amounts of income to be deferred but only at the cost of lost growth on the income deferred.  If the investment returns exceed the assumed rate of return upon which the plan was premised, the amount of retirement income will not increase.  The extra investment returns simply reduce the employer’s future contributions to the plan.  With other deferred compensation plans, such as a 401(k), the employee’s retirement benefit increases as the performance of the plan investments exceed expectations.  The 412(e)(3) Plans are locked into a set rate of return so participants will not receive the benefit of a bull market.

        In addition to being conservative investment vehicles, 412(e)(3) Plans have some other negative attributes.  412(e)(3) Plans must meet with the same coverage and nondiscrimination rules that all qualified plans must meet.  412(e)(3) Plans cannot make loans and the company cannot skip a year of funding after establishing the plan. Most importantly, 412(e)(3) Plans are not appropriate deferred compensation plans for individuals with a taxable estate because the death benefit will be part of the decedent’s gross taxable estate.

    The Ideal Candidate to Participate in a 412(e)(3) Plan.

        The ideal candidate to participate in a 412(e)(3) plan is a small business owner approximately age 50 or older with few employees.  The business must be economically stable with consistent annual income in order to make the annual payments the plan will require.  The payments cannot be forgiven or deferred for a year in the event the business profits are not as expected.  The ideal candidate will be operating a successful small business which can benefit from the deferral of substantial amounts of income.  412(e)(3) Plans are more appropriate for people age 50 or older as the plan will require larger contributions because the annuity will be for a shorter length of time since the employee is nearer to retirement.  412(e)(3) Plans are also good plans for investors who desire a guaranteed return as they will not be affected by the stock market.