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There is a wide variety of planning tools and techniques available for our clients who are self-employed or own a small business. Most of us are familiar with the defined benefit pension plan, and many of our clients participate in such plans. Today we will address one specific defined benefit plan type - the one authorized by Section 412(i) of the Internal Revenue Code.
The Section 412(i) plan is one where the benefits under the plan are provided through life insurance or annuity contracts guaranteed by a life insurance company. In this sense, it is unlike other defined benefit plans which are funded by employers who invest their plan contributions in a variety of securities and other investments. The Section 412(i) plan also differs from the more traditional defined benefit plans in that it is not subject to the same complex tax rules, if the plan meets certain stated requirements.
Among these requirements are that the insurance or annuity contract premiums must be level and must terminate at the participant's retirement and no later. Further, the plan must use the same mortality tables and rates for all participants. There may be no security interest given in the contracts and no loans may be taken from them. If these requirements are fulfilled, then we have a fairly simple technique that provides a variety of worthwhile benefits. It is also important to note that such plans are not subject to minimum funding requirements or high annual cost to participants that may be associated with a "regular" defined benefit plan under Section 412.
The advantages of a Section 412(i) plan are substantial. First, the plan allows participants to use tax deductible contributions to fund amounts far above the limits applied to most retirement plans and without the limitations imposed by ERISA. Contributions may be on the order of $250,000 or more annually, which translates to significant current income tax savings for the employer and the participant. Second, the funds contributed are typically exempt from creditors of the business and of the participant, which is an extremely valuable feature, particularly when we consider the large amounts that may be contributed. In addition, the contract may provide protection for the participant's heirs through a death benefit, while providing significant tax-deferred benefits to the participant.
Despite these advantages, we need to be aware of some important limitations and considerations. First, there are limits to the income tax deductions associated with the contributions. Second, the payment of benefits to the participant is generally subject to taxation as ordinary income when received. Third, since the plan is funded exclusively through life insurance and/or annuity contracts, the flexibility of investment in these contracts is very limited. Fourth, the contracts cannot be pledged and loans may not be taken against the insurance contracts. Finally, the Section 412(i) plan works best where the self-employed individual or small business is established and profitable so that the participant(s) may take advantage of the plan's strengths.
Examining the Section 412(i) Plan in Practice
Which of our clients might benefit most from the Section 412(i) plan? At the outset, we noted that they can be beneficial for the self-employed and owners of small businesses. We know many clients that fit this description and may wish to illustrate to them the impact of participation in such a retirement plan. Our discussion above mentioned the need for an established business that generates high income to support the high level of contributions possible. One such type of client is a physician, though many other professionals and small businesses may qualify.
In our case study, we will review the situation for a married physician earning an average of $750,000 annually and wishing to build a substantial retirement nest egg. In our base scenario, using a combination of traditional taxable investments and the maximum traditional tax-deferred investment under ERISA, we will determine the impact of saving $250,000 annually during the client's expected working life until retirement at age sixty. Figure 1
The results are impressive - at the current rate of savings the client will likely amass a significant retirement portfolio capable of supporting a broad range of goals. However, this approach has some disadvantages relevant to our client. First, the greater share of contributions is made in after-tax dollars and we have done nothing to address the income tax burden faced by the physician on this very large stream of income. Further, knowing that the practice of medicine is an occupation liable to litigation, there may be a level of discomfort in saving money that may be attached by future, unknown creditors.
Making our contributions to a Section 412(i) plan instead of the more traditional vehicles employed in the base scenario may address both of these issues. (Though there are other strategies, we will keep our focus on the subject plan). The rules applicable to the Section 412(i) plan encourage us to invest in the plan because of the enormous tax breaks associated with the contributions. Not only are the contributions not subject to the limits applicable under ERISA, but once contributed, the assets are no longer within the easy reach of potential future creditors of the plan participant. In Figure 2 we will compare the initial scenario with one where our same level of savings is directed to a Section 412 (i) defined benefit retirement plan.
This illustration restates the value of tax-deferral over time, with a much higher upside potential in almost every possible circumstance available through the use of the Section 412(i) plan. Though the income tax reduction each year is not reflected in this analysis (we have assumed that the difference is spent and not saved), it will have a significant impact on the client's pre-retirement lifestyle and could offer investment opportunity as well. In addition, the value of asset protection from potential creditors cannot be overstated, particularly in the case of our client, a physician, who works in the shadow of medical malpractice claims every day. The analysis provides strong support for consideration of the Section 412(i) plan for those clients not currently participating in one.
The extremely high likelihood of achieving the stated goals reflected in Figure 2 suggests that the client is sacrificing too much in his current lifestyle to achieve those goals. Introducing the Section 412(i) plan provides the advisor with an opportunity to work with the client to refine goals and priorities to take reduce the level of sacrifice apparent in the results. Among the options the advisor and client may consider are increasing retirement spending and/or the estate target, decreasing the investment portfolio risk, or the adding other spending goals and priorities in the advice. The bottom line is that the client will be able not only to reduce his current income tax burden but may direct the flow of the dollars saved to enhance his personal goals.
Protecting our client's interests while fulfilling their dreams. This is the future of financial advising.
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