Steven L White

A couple months ago I introduced you to the Internal Revenue Code 412(i) qualified defined benefit retirement plan. Remember that this retirement strategy allows you to define your retirement benefit with a fully insured plan. This fully insured plan also allows you to defer income significantly above the typical $45,000 plus catch up provisions for defined contribution plans.  Remember these plans are funded with life insurance and annuities and typically tailored for high income wage earners with shorter retirement time horizons. For example, someone in their late 40’s, 50’s or 60’s. (younger folks who qualify must of course be included in these retirement plans). I thought it would be a great idea to show you a “sample” case study so that you can compare and contrast the difference between a Defined Contribution Plan and the fully insured Defined Benefit Plan IRC 412(i) which will become  IRC 412(e)3 effective in 2008. 

First the set up:  The Participant is a family doctor, male, mid 50’s. He has 3 participating employees with ages ranging from 23 to 40 and average compensation of $37,000 per year. The Doctor has an income tax burden of $200,000 for 2007. (He’s not real excited about this.) The doctor’s income is extremely stable and he plans to retire in 12 years.   

Present situation: The doctor is contributing to a Defined Contribution Plan  401(k) account to the maximum of $45,000. In this example the Doctor will have accumulated $1,600,000 by the end of 12 years. Over the same period of time the doctor will pay Uncle Sam $2,400,000 in income taxes. ($200,000 x12 =$2,400,000). He is not happy about that either. Now let’s spend it down at retirement. Let’s pretend the doctor takes $150,000 per year from his 401(k) retirement plan and it continues to grow at a rate of 5% per year. In 9 to 12 years it is possible that he runs out of money if we factor current rates of inflation, current interest rates and existing tax brackets.  

Contrast this to Future situation: The doctor decides to create a Defined Benefit Plan under IRC 412(i). In this example let’s use the same numbers as above however let’s shift the tides a bit. Let’s take the $200,000 and pay $170,000 to “himself” as a contribution into the plan. In this example his tax liability has been reduced by approximately $27,000 from $200,000. Assumption is that the doctor’s taxable income places him in the 28% tax bracket of the current tax code. This results in the doctor recapturing approximately $2,000,000 over the next 12 years and he is extremely happy with this. He is even more excited that his deductible contribution to his retirement plan jumped from $44,000 with the defined contribution /401(k) to $170,000 per year contributions made by him on behalf of his employees would of course also be deductible! In this example the doctor is able to accumulate approximately $3.1 million of guaranteed money inside his plan (subject to some market risk)   which will pay out a guaranteed retirement income of $175,000 (2006 limits) per year until death. This is a much better outcome than running out of income using the 401(k) strategy. 

Remember, IRC 412(i) allows the lesser of 100% or salary or $180,000 for 2007 as retirement benefit.  You can not ignore the possibility of a 412(i) plan as a viable alternative to your current tax and retirement strategy.  As always be sure to consult with your highly qualified, credentialed tax professional when addressing and gaining an understanding of the Internal Revenue Code before making any decisions.   

Steven L White

Wealth Strategies Group

Park Avenue Securities LLC,(PAS) and its representatives do not give tax or legal advice

You are halfway through 2007, maxed out on your current qualified retirement plan, earning incredible income and are concerned about 2 thoughts. One, how do I retire with a decent cash flow when I can only defer a fraction of my incredibly large income? Secondly, with my significant amount of income how can I defer larger amounts of income to create a better retirement distribution? Congratulations, you have just graduated from the typical qualified retirement plan menu of defined contribution plans that are typically associated with lower gross incomes. 

No worries, there is a solution that is commonly used with high-income earners.  This qualified plan you may want to consider is a section 412(e)(3) fully insured plan  (formerly know as 412(i)) because of the section of the Internal Revenue Code which authorized it. Unlike traditional tax qualified “defined contribution” plans such as an IRA, 401k and Simple plans this is a tax qualified “Defined-Benefit” plan. So instead of the monthly contribution and the long-term growth or loss of principal of your contribution determining your retirement distribution ,  a “defined benefit” plan determines your actual benefit paid out at retirement, currently maximum is $180,000 per year…guaranteed and with significantly larger annual deferrals going into the plan, some as high as $200,000+ in one year.

The main characteristic of a section 412(e)(3) plan is that it is a “defined benefit” plan in which the plan benefits are funded entirely by insurance and annuity contracts or solely  by annuities issued by a reputable  insurance company with a long and favorable track record. This kind of contract is funded by level premiums that begin when an employee becomes a plan participant and end no later than the employees end retirement age under the specific plan.

Some of the characteristics that make the 412(e)(3) attractive are no full funding limitation or current liability test to limit the employers deduction which makes significantly larger deductions possible. With increased funding, larger benefit payouts are likely at retirement subject to IRS limits, and these plans are exempt from the minimum funding standards. If death of the participant occurs before retirement, a portion of the beneficiaries’ death benefit is income tax-free rather than 100% taxable as is the account value of more “vanilla” type of retirement plans.

Anything of great value and benefit does have a downside. These plans do not allow loans and tend to have less investment flexibility than other qualified plans so it is a give-and-take scenario for the well informed participant and plan sponsor.

Who could benefit from a properly funded 412(e)(3) plan? A Great question! A generally suitable situation is a Self employed man or woman in late 40’s, 50’s or more, earning a healthy, steady and  stabilized  6 figure income who feels they have not put enough away for retirement and want a viable option to help them catch up and take advantage of significant tax deferrals now. This person generally owns his or her own business and has a handful of employees. A 412(e)(3) could be just what the doctor ordered and an incredible vehicle to move you closer to your financial and retirement aspirations. As always, please consult with qualified professionals in advanced planning with these kinds of plans as they are highly specialized. Free feasibilty study offered upon request!
As seen in The Villager Newspaper-Steven L White