We all know about the advantages of cash balance plans. But what about other retirement plans for small business owners? In this post we take a look at a 412(e)(3) pension plans. They are little known but are a great solution for many business owners.
Not only are we going to examine some of the pros and cons of the plans but also take a look at the FAQs. Few investment advisors or tax advisors understand how they work, so we will try to break down the barrier.
What are 412(e)(3) plans?
A 412(e)(3) plan is a defined benefit pension plan. But rather than using the plan assets to invest in stocks, bonds, and mutual funds, the plan benefits are guaranteed with insurance contracts, including life insurance. Some professionals refer to 412(e)(3) plans as fully insured defined benefit plans.
What is the difference between traditional defined benefit plans and 412(e)(3) plans?
412(e)(3) plans are only allowed to invest funds in annuity contracts and permanent life insurance. The plans will offer participants a guaranteed return. Defined benefit pension plans are allowed to invest in the same insurance contracts, but also can invest in traditional investments like stocks and mutual funds. Defined benefit plans can offer higher returns, but since 412(e)(3) plans offer guarantees they can protect against investment downside.
What are the advantages of 412(e)(3) plans?
There are many advantages of 412(e)(3) plans:
- They offer stable investments returns without market fluctuations.
- They provide flexibility and security based on the guaranteed insurance contracts.
- Because of the assumed lower rate of return, companies can generally make substantially higher tax deductible contributions compared to traditional defined benefit plans.
- They allow companies to fund larger contributions for older employees that will not increase contributions for younger employees.
- Because they do not require an actuary, they will generally allow for lower administrative costs compared to traditional defined benefit plans.
What are the disadvantages of 412(e)(3) plans?
Some of the disadvantages include:
- Since they use only insurance products, the investment returns tend to be lower.
- They can require large contributions, especially in early years.
- They do not allow loans.
- The annual contributions are fixed, so there is no ability to increase or decrease based on circumstances.
- While the plan is open, annual contributions are required and are not elective.
- Even though administrative costs are lower than traditional defined benefit plans, they are higher than 401k plans.
How does a 412(e)(3) plan work?
The plan works as follows:
- A qualified third party administrator is chosen and the plan is designed and drafted.
- The plan is funded and acquires qualified annuities and possibly life insurance contracts.
- On an annual basis, the third party administrator provides compliance and reporting services.
- The company will level-fund the plan during the working life of each participant.
- Upon retirement, the promised benefit based on the insurance annuity is utilized by the retiring participant.
What are the 412(e)(3) plan requirements?
Can you borrow from a 412(e)(3) plan?
What is the maximum benefit under a 412(e)(3) plan?
How safe is a 412(e)(3) plan?
How are contributions determined?
How much can you contribute to a 412(e)(3) plan?
Are contributions to a 412(e)(3) plan tax deductible?
Can the company take a tax deduction for plan set-up fees and annual administration costs?
Does the plan cost anything to participants?
Does an actuary sign off on the plan?
Can a 412(e)(3) plan be combined with other plans?
- 401(k). Subsequent to January 1, 2002, a company is allowed to retain its 401(k) plan and also adopt a 412(e)(3) Plan.
- Profit Sharing Plan. The company is allowed to have a profit sharing plan. However, the profit sharing contribution would typically be limited to 6% of compensation if the 412(e)(3) plan is not covered by the PBGC.
- Defined Benefit Plan: Since a 412(e)(3) plan is a form of defined benefit plan, it is recommended that the company terminate any existing defined benefit plan. Any accrued benefit of the prior defined benefit plan would lower the maximum benefit of a new 412(e)(3) plan.
What type of companies can adopt a 412(e)(3) plan?
Can a 412(e)(3) plan be structured to make contributions at a specified level?
Is annual funding mandatory?
Who are qualifying employees under the plan?
What happens when a participant retires?
412(e)(3) plans can be great plans for small business owners. Unfortunately, most advisors and financial planners are not familiar with them. We have examined many of the pros and cons and also many FAQs. Hopefully, you are now well versed on how the plans work and can determine if a plan is right for you.