1. 412(e)(3) Plans Beyond the Basics
I am here to talk to you today about 412(e)(3) plans – when to use them and how they work. 412(e)(3) plans have become quite popular lately and I’ll explain some of the reasons I think they have become popular.
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CRN

2. Disclosure
This presentation is not written or intended as specific tax or legal advice and cannot be relied upon for purposes of avoiding any federal tax penalties.
MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from a qualified tax or legal advisor.
A 412(e)(3) plan must be funded exclusively with individual insurance products, either fixed annuities or a combination of fixed annuities and life insurance.
Securities offered through registered representatives of MML Investors Services, Inc., 1295 State Street, Springfield, MA
Before I begin please remember that this presentation is not written or intended to be specific tax or legal advice. Therefore, you may not rely upon this information for the purposes of avoiding any federal tax penalties. Please seek legal advice from a qualified tax or legal advisor.
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3. Overview A 412(e)(3) is a defined benefit plan.
This means the contribution to plan is determined by the benefits to be paid at retirement.
The plan must be sponsored by an employer.
To start with I am going to present an overview of what a 412(e)(3) plan is. Fundamentally, a 412(e)(3) plan is a defined benefit pension plan – a qualified retirement plan. As a qualified plan it has to be sponsored by an employer for employees and we will talk about what employers can establish such a plan. I just want to spend a moment reviewing what a defined benefit plan is. A Defined Benefit plan is a plan that establishes a monthly pension benefit for each employee at his or her normal retirement date. Usually that benefit is based on a percentage of salary. Then the contributions the employer makes to the plan are calculated so there is enough money in the plan to pay the benefit to the employee.
So, for example, if an employee is to get a $5,000 monthly benefit at age 65, that’s the defined benefit. The employer must make annual contributions to the plan to have enough money in it to provide the promised monthly benefit to the employee at retirement.
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4. Qualified Plan Subject to All Requirements
Because a 412(e)(3) plan is a type of qualified retirement plan, it must meet all applicable funding and discrimination rules by the Internal Revenue Service and Department of Labor.
Plans are required to cover all eligible employees.
Full-time (over 1,000 hours per year) employees over the age of 21
Certain plans must meet top heavy requirements.
Because a 412(e)(3) plan is a qualified plan under the tax rules it has to cover all eligible employees. Usually this means that all full-time employees over the age of 21 have to be covered. Full-time employees are those working more than 1,000 hours a year. In general, the plan must also be nondiscriminatory. There are a series of specific tests for discrimination but I am not going to go into the details here.
The TPA or administrator of the plan is responsible for keeping the plan in conformity with the rules and making sure the plan is nondiscriminatory. Basically, the employees/participants have to have the same benefits as a percentage of pay. For example, the retirement benefit could be 50% of pay for everyone, but not 80% for the owners and 30% for the rank and file. But, there are also ways to integrate the plan benefits with Social Security benefits that the TPA may be able to use in the design of the plan to favor higher paid employees. We do not do plan design or administration; this is something for the TPA.
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5. Establishment of the Plan
Plans are easy to establish.
Prototype documents are available for § 412 (e)(3) plans.
Plan can be established by the following:
S Corporation
C Corporation
Limited Liability Company
Partnership, or
Sole Proprietor
The 412(e)(3) plan is easy to establish. As with any defined benefit plan there are prototype documents available. Volume submitter documents are also used and are usually available from the plan administrators. Massachusetts Mutual Life Insurance Company has a prototype document that is available for a fee. Plans can be set up in a very short period of time so the employer can make deductible contributions. The amount of deductions that can be made in the early years is one of the big benefits of the 412(e)(3) plan. I mentioned that a 412(e)(3) plan must be sponsored by an employer. The plan can be established by an S Corp; a C Corp; a partnership; a Limited Liability Company; or a sole proprietor. A sole proprietor with no employees is an excellent candidate for a 412(e)(3) plan.
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6. Importance of Third Party Administration
Design plan
Census
Other documentation
Annual reporting
Establish plan and trust
Tax reporting – Form 5500
Implementing a 412(e)(3) plan is a detailed process that requires: identifying the appropriate case design and preparing suitable proposals, making sure that all the required forms have been submitted, and ensuring that appropriate administration of the plan is followed. The administration of a defined benefit plan is critical to the proper implementation of a 412(e)(3) plan. A Third Party Administrator (TPA) has the range of knowledge and experience to help provide you with guidance that can cover: establishing a plan on or before the close of the tax year, contributions are paid by the employer to the trustee prior to filing the corporate tax returns, contributions are invested by the trustee, and required forms are properly filed with the IRS, Department of Labor and Pension Benefit Guaranty Corporation.
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7. What is Special About 412(e)(3) Plans?
IRC § 412 is entitled “Minimum Funding Standards.”
This section sets out rules for determining funding of Defined Benefit Plans.
Each year, a Defined Benefit Plan has to be reviewed and present value of liabilities for benefits must be determined by an actuary.
Assumptions made on cost of retirement benefits and “investment” returns.
What is special about 412(E)(3) plans? I said 412(e)(3) plans are fundamentally a defined benefit plan. What’s different about 412(e)(3) is it’s an exception to the general rules of 412 that require actuaries to calculate the amount of contributions to fund a defined benefit plan. With a hypothetical participant who is going to get $5,000 a month at normal retirement an actuary has to make an assumption as to how much money it will take to provide that benefit at retirement and how much has to be contributed to the plan each year to accumulate that amount between now and normal retirement to fund for that benefit. That is what 412 is all about – determining how to fund for the defined benefit of all the participants.
What is special about 412(e)(3) is that it is an exception to those general funding rules and provides that if everything in the plan is guaranteed by an insurance company. You do not need to hire an enrolled actuary to make actuarial assumptions, you can rely on insurance company guarantees. Principally we are talking about two big guarantees that insurance companies make. One is that that $5,000 a month benefit will be provided if a certain amount of cash is accumulated at normal retirement. The second is the guarantee in the annuity or life insurance contract funding a 412(e)(3) plan as to how much will be accumulated in the contracts to get us to that amount needed to provide that benefit.
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8. Fully Insured Plans Under §412(e)(3)
412(e)(3) is an exception to general rules of §412.
With a 412(e)(3) plan, insurance company’s guarantees take place of actuarial analysis mandated by §412.
The Guaranteed Annuity purchase rate determines amounts needed to fund benefit
The guaranteed accumulation or cash accumulation rates determine “investment” performance
Since 412(e)(3) is an exception to the general rules you have to meet special rules to qualify for the exception. Basically the plan is based on the insurance company guarantees to take the place of the actuarial analysis otherwise mandated by 412.
Of course, any guarantees are subject to the claims paying ability of the insurance company.
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9. Impact of Qualifying Under §412(e)(3)
No minimum funding standard account.
No full funding limitation.
No reasonable actuarial assumptions.
No Schedule B Form 5500 Enrolled Actuary Certification needed.
Now, if you qualify under 412(e)(3) several things flow from that. There is no minimum funding standard account; there is no full funding limitations; no quarterly contributions are required. This can be an important factor for employer-sponsors. Normally with a defined benefit plan the employer has to make quarterly contributions to the plan. A 412(e)(3) plan is typically administered on an annual basis and the contributions for the entire year can be made annually. In fact, they can be made up until the tax filing deadline for the entire year. Many employer-sponsors find this beneficial, rather than having to make the contribution on a quarterly basis. It also makes the administration somewhat easier because the administrator of the plan is only looking at the plan on an annual as opposed to a quarterly basis. Because we are relying on insurance company guarantees, no actuarial assumptions are made and, therefore, no Schedule B Certification for the Form 5500 is needed. The Form 5500 is the IRS form that all qualified plans have to file. Schedule B is the actuary’s certification that the contributions will properly fund the benefits promised in the plan. Guarantees are based on the claims paying ability of the issuing company. Also note that the dividends are not guaranteed and may be lower than those shown in the hypothetical examples in the presentation.
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10. Qualification Under §412(e)(3)
The plan must be funded entirely with annuities, or annuities and life insurance;
The contracts must provide for guaranteed level annual premiums to be paid during anticipated normal working years;
To qualify under 412(e)(3) and be exempted from the general rules of 412 the plan must be funded exclusively with annuities or annuities and life insurance contracts. The annuity and insurance contracts must provide for guaranteed level annual premiums to be paid during the normal working lives. That does not necessarily mean that the payments will remain level, only that on the guaranteed basis the insurance company has promised that based on contract guarantees the contributions are level through normal working years. Dividends or interest in excess of the guaranteed amounts are used to reduce future contributions. This is why the 412(e)(3) plan needs fixed and guaranteed contracts. Contracts that do not provide those kinds of guarantees can not be used to fund a 412(e)(3) plan.
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11. Qualification Under §412(e)(3) continued
The benefits must be guaranteed by an insurance company;
The premiums for current and all prior years have been paid;
The plan cannot have any outstanding loans;
The performance in excess of guarantees must be used to reduce future contributions.
There are additional qualifications. First, the premiums for the current and all prior years must be paid each year, they cannot be skipped. No loans can be taken from the contracts and the plan cannot make any loans to employees. The performance in excess of the guarantees must be used to reduce future contributions. A 412(e)(3) plan will not necessarily have, and probably won’t have, level payments. The reason is because in most years the performance of the contracts will exceed the guarantees and to that extent future contributions are going to be reduced. It is typical of 412(e)(3) plans to have the contributions each year decrease a bit over time because of the performance in excess of the guarantees. Basically, the funding assumption is that the contracts will perform right at their guaranteed levels.
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12. Why are §412(e)(3) Plans becoming Popular?
They can generate large deductions because contributions are based on insurance company guarantees.
Guarantees are subject to claims paying ability of insurance company.
Retirement Benefits can be paid to a maximum of $195,000(2009) annually at age 62 (reduced from 65 by EGTRRA*).
*This law contains a “sunset” provision that repeals the Act as of December 31, Consequently, all tax code changes made under the Act will revert to their status prior to enactment once again on January 1, Unless there is future legislation the Act will only be effective through the year 2010.
Why are 412(e)(3) plans becoming so popular? First, they can result in large deductions. They can do this because the contributions are based on the insurance company guarantees, which are typically less than the assumptions an actuary would otherwise have to use. For example, if a 3% interest rate is assumed it will require higher annual contributions than if 5% was assumed.
Of course, the guarantees are subject to the claims paying ability and the financial strength of the insurance company.
A second related reason is that in 2001 Congress increased the maximum target benefit and reduced the normal retirement age from 65 to 62. This decreases the time of funding until normal retirement. The maximum benefit of $195,000(2009) a year ($16,250 monthly) can now be funded to age 62 as opposed to age 65 (three years less funding). That means much more of a contribution necessary to get to that same amount to provide a benefit of $195,000(2009) a year.
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13. Why are §412(e)(3) Plans becoming Popular?
Guaranteed benefits* not subject to investment risk.
*Guarantees are subject to the claims-paying ability of the issuing companies.
The biggest reason for the increased popularity of the 412(e)(3) plans, I believe, has to do with the fact that fixed products are becoming more appealing. In the late 90s people were more excited about the investment returns being generated by the equity market. The last several years of negative returns in equity markets have changed people’s perspective and guaranteed investments have become more acceptable. Fundamentally, I think that is the primary reason 412(e)(3) plans have enjoyed a resurgence of popularity. They also have the ability to provide life insurance protection and all the benefits are guaranteed. There is very little risk for people in a 412(e)(3) plan as far as not getting what they think they are getting.
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14. Life Insurance in a §412(e)(3) Plan
Life Insurance contracts can be used in addition to annuities.
Life Insurance is subject to “incidental benefit” limitation generally applicable to defined benefit plans:
Treas. Regs limit face amount to 100 times anticipated monthly benefit; or
Rev. Rul allows up to less than 50% of contribution toward ordinary life premium.
In most plan documents the limit is expressed as 66 ⅔ of the theoretical premium.
This is an actuarial approximation of 50% of the contribution
Although 412(e)(3) plans can be funded 100% with annuities, they can also be funded with a certain amount of life insurance. There is a limit on the amount of life insurance that you can put in any defined benefit plan including a 412(e)(3) plan. There are two principal limits and let me explain why there are limits at all. A pension plan is primarily a retirement benefit plan, but the IRS and the Treasury Department have allowed life insurance in a retirement plan as long as it is incidental to the principal purpose of providing retirement benefits for the employees.
These limits are known as the incidental benefit rules. There are two rules that apply. The first rule, which is found in the regulations, says that if life insurance is limited to 100 times the anticipated monthly benefit (going back to my first hypothetical with a participant who is anticipating getting $5,000 a month at normal retirement, one hundred times that number will limit the face value of the life insurance – for that participant to $500,000). The IRS says that amount of insurance is okay; it is incidental to the primary purpose of the plan, which is to provide retirement plans. A second limit comes from a 1974 revenue ruling that provides that if less than 50% of the contributions are made to a whole life insurance policy that will be considered incidental. This second test will always yield more life insurance, and I’ll refer to it sometimes as the maximum life insurance scenario vs. the 100 times the monthly benefit limit of insurance.
In most plan documents the less than 50% limit is expressed as 66 ⅔ of the theoretical premium. This is an actuarial approximation of 50% of the contribution.
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15. Why have Life Insurance in Plan?
Can provide an additional death benefit.
The “Economic Benefit” is taxable each year.
IRC 72(m)3(b), Reg. Sec (b): each participant is taxed on the “pure” life insurance benefit.
The “pure” insurance (net amount at risk) is received income tax free by participant’s beneficiaries.
Why have life insurance in a plan? Because it can provide a substantial benefit to the insured’s beneficiaries in case of premature death. If the participant lives to retirement, the retirement amounts will be paid over the employee’s lifetime, or a reduced amount could be paid for the joint life of the employee and his/her spouse. But, there may be very little in the plan for a spouse or other beneficiary if the employee dies before retirement. Life insurance provides a pre-retirement benefit.
I want to explain how the life insurance works in a 412(e)(3) plan. The cash values of a whole life policy are assets of the plan used to calculate the funding of a 412(e)(3) plan. The death benefit in excess of the cash value (the net amount at risk or pure insurance) is paid income tax-free to the insured’s beneficiary. The value of the protection is an economic benefit that is reported as taxable income by the participant each year. The measured of this value is either the IRS Table 2001 rates tables, or an insurance company’s qualifying alternative term rates. MassMutual uses its NCT rates to value the economic benefit. If the participant needs life insurance, this is a great way to pay for it.
The second reason to have whole life insurance in a 412(e)(3) plan is the availability of the life insurance for the participants who might not otherwise buy a permanent policy. The policy can be either swapped out of the retirement plan or rolled out to the participant. This enables the participant to have the policy available for future uses where he might not otherwise have purchased a whole life insurance contract.
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16. Contribution Examples
The following examples are all based on the guaranteed rates of the MassMutual Odysseysm Annuity and Pension Whole Life Legacy 65 (paid-up at 65). The Guarantees are subject to the claims-paying ability of the issuing companies.
MassMutual Odysseysm is issued by Massachusetts Mutual Life Insurance Company (MassMutual) in New York and by C.M. Life Insurance Company, a MassMutual subsidiary, in all other states. Whole Life Legacy 65 is issued by MassMutual.
The illustrations used in this presentation are purely hypothetical and are used solely to demonstrate the general concept of 412(e)(3) plans.
The following illustration assumes a guaranteed rate on the Odyssey annuity of 2% for the first 10 years, 3% thereafter. This rate is applicable in many states, however, contracts issued in other states may have different and higher rates which change the following calculation.
We will look at some examples of three ways to fund a 412(e)(3) plan. The first two examples will be a combination of life insurance and annuities, and the third will be annuity only funded. These examples will be based on the guaranteed values of our MassMutual Odyssey annuity and pension series whole life legacy 65 policy. All of these examples are based on the guarantees of MassMutual and its subsidiaries. The guarantees are limited, of course, to the claims paying ability of the issuing companies.
In the following examples, we assume that the policy is underwritten as Select Preferred, Non-tobacco.
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17. Example for 42 Year Old (unisex – select preferred non-tobacco)
Retirement age of 65 and an anticipated retirement benefit of $10,000 per month and Whole Life Legacy 65 –100 x monthly benefit.
Value required at retirement to produce life only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) $1,996,008
Face amount of life Insurance policy 1,000,000
Life insurance policy premium $21,200.00
Premiums are payable to age 65
Level annual annuity payment $44,962.75
This first example is an example of a 42 year old participant with a planned pension of $10,000 a month starting at age 65. This example is funded by a combination of annuity and life insurance with a death benefit equal to 100 times the monthly pension, or $1,000,000. The examples show what the first year contribution would be. Now, on this first line you will see that we need to accumulate $1,996,000 to fund a $10,000 a month benefit for this individual. Next is the face amount of the life insurance policy. The guaranteed level life insurance premium is $21,200. This assumes the insured is a select preferred non-tobacco. Dividends must be used to reduce future premiums. The level annuity payment is $44,962 for a total contribution the first year of $66,162.
Total annual outlay (annuity premium + life insurance premium) $66,162.75
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18. Example for 42 Year Old (unisex – select preferred non-tobacco)
Retirement age of 65 and an anticipated retirement benefit of $10,000 per month and Whole Life Legacy 65 based on less than 50% of contribution.
Value required at retirement to produce life only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) $1,996,008
Face amount of life insurance policy 1,627,645
Life insurance policy premium 34,474.69
Premiums are payable to age 65
Level annual annuity premium 34,621.90
Total annual outlay (annuity premium + life insurance premium) $69,096.59
Next is an example of 50/50 funding. We start with the same $1,996,00 required at 65 to provide the $10,000 monthly pension. What has changed here is the amount of life insurance. I have increased the amount of life insurance to the amount of life insurance that could be bought with just less than 50 percent of the contribution. Keeping within the incidental benefit rule, and giving us what I call our maximum life insurance scenario, we have a level life insurance premium of $34,474 a year and level annuity payment of $34,622, for a total contribution of $69,096.
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19. Example for 42 Year Old (unisex)
Retirement age of 65 and an anticipated retirement benefit of $10,000 per month and no life insurance.
Policy: MassMutual Odysseysm Fixed Annuity
Anticipated Monthly Benefit 10,000.00
Value required at retirement to produce life only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) 1,996,008
Level annual annuity payment $61,438.39
In the third example, keeping all of the other assumptions the same, but funded only with an annuity (no life insurance) the annual contribution is $61,438.
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20. Example for 52 Year Old (unisex – select preferred non-tobacco)
Retirement age of 65 and an anticipated monthly retirement benefit of $10,000 and funded with Whole Life Legacy x monthly benefit.
Policy: MassMutual Odysseysm Fixed Annuity
Value required at retirement to produce life only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) $1,996,008
Face amount of life insurance policy 1,000,000
Life insurance policy premium 43,380.00
Premiums are payable to age 65
Level annual annuity payment 94,927.83
Total annual outlay (annuity premium + life insurance premium) $138,307.83
Now, we illustrate the initial funding for a 52 year old keeping the other assumptions; still using the same life insurance contract, which is the LPL65; same underwriting class, and we are funding to $10,000 a month benefit. In this scenario the life insurance is limited to 100 times the monthly benefit or $1,000,000. Our level life premium is $43,380 and our annual annuity payment is $94, for a total first year contribution of $138,307. With a 42 year old we were funding from ages 42 to age 65 = 23 years. Here we have 13 years left from age 52 to age 65. This decrease in funding time increases the required contribution.
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21. Example for 52 Year Old (unisex – select preferred non-tobacco)
Retirement age of 65 and an anticipated retirement benefit of $10,000 per month and funded with Whole Life Legacy 65 limited by Rev. Rul
Anticipated Monthly Benefit $10,000.00
Value required at retirement to produce life only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) 1,996,008
Face amount of life insurance policy 1,655,987
Life insurance policy premium 71,803.92
Premiums are payable to age 65
Level annual annuity payment 72,109.79
Here’s the 50/50 funding based on the same example. Everything stays the same but we increase the life insurance to the amount that could be purchased with less than 50 percent of the contribution. We have a level life insurance premium of $71,804 and an annual annuity payment of $72,109 for a total of $143,913. It’s roughly twice the amount that would be require for the 42 year old.
Total annual outlay (annuity premium + life insurance premium) $143,913.71
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22. Example for 52 Year Old (unisex)
Retirement age of 65 and an anticipated monthly retirement benefit of $10,000 and no life insurance.
Anticipated Monthly Benefit $10,000.00
Value required at retirement to produce life only monthly benefit (based on annuity purchase rate in MassMutual Odysseysm) 1,996,008
Level annual annuity payment $129,712.12
In this slide we’re funding entirely within an annuity and the annual contribution is $129,712.
Now, all of these numbers should be put in context of what could be contributed for other types of plans. The maximum right now that could be funded into a profit sharing plan for a participant is $46,000 or 25 percent of covered compensation. For the individual described here the deduction to a 412(e)(3) plan is a lot higher. The deduction is also higher than what could be put in other defined benefit plans because, as we talked about, the funding assumptions are “lessor” for 412(e)(3) plans.
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23. §412(e)(3) Summary of Age 52 Year Old Contributions & Comparison with Results for a 42 year old
Retirement age of 65, anticipated monthly retirement benefit of $10,000;
Insurance Product LPL 65 (uni-Sex rates) Select Preferred Non-Tobacco
Starting Age: Age Age 52
Annuity Only Arrangement $61, $129,712
Life 100x mo. Benefit $66, $138,308
Life Death Benefit ($1 million) ($1 million)
Life < 50% Contrib $69, $143,914
Life Death Benefit ($1,627,645) ($1,655,987)
This slide is a comparison of all of the examples that we just looked at. There are two things that I want you to notice here. First the graphic difference in the costs and available deduction by starting the planning process 10 years later. Second, for the client who needs life insurance death benefit protection, lets look at the incremental cost of adding life insurance. For example, for a 52 year old client, the incremental cost of adding a $1 million permanent life insurance policy is $13,100 tax deductible dollars. For your client in a 40% tax bracket, you’re looking at out of pocket costs of less than $7,900 for $1 million of life insurance. And for a mere $3,330 additional, the life insurance policy can be increased to $1,425,000.
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24. Investment Performance of Policies
If annuity generates income in excess of guarantee, that increase is used to reduce next year’s premium.
Dividends in excess of guarantee on life insurance policy must be used to reduce premiums.
To the extent performance exceeds guarantees, the costs of the plan will be reduced over time.
If the annuity generates income in excess of the guarantee that excess has to be used to reduce future contributions. The Administrator of the plan will have to calculate what that next year’s contribution is, taking into account any increased investment performance. Therefore, to the extent that investment performance exceeds guarantees, the payments of a 412(e)(3) plan will be reduced over time. Likewise, dividends in excess of the guarantees on the life policy have to be used to reduce premiums for the next year. Please note the dividends are not guaranteed.
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25. What Happens to Life Policy at Retirement?
Policy may not be kept in Plan. Only “participants” can receive life protection.
Policy can be distributed as a partial lump sum distribution. The distribution will be income taxable.
Policy can be purchased from plan by the plan participant at fair market value.
Policy can be surrendered and the cash used to provide retirement benefit.
The options at retirement are in general dependent on the terms in the controlling plan document. The plan will no longer be allowed to hold life insurance as an asset and the policy will either have to be transferred out of the plan (this will be a taxable event to the extent of the policy’s fair market value FMV), sold in exchange for cash or the policy can be surrendered. If the policy is transferred to the participant the policy can continue to provide valuable life insurance protection and cash accumulations beyond retirement if the participant desires. In the proper situation it may be desirable for a trust established by the insured to purchase the policy for its fair market value. Depending on its value and value to the employer of the deductions in funding the plan this can be a very tax efficient method of getting assets out of the estate that will yield income tax free death benefits.
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26. Example of Sale of Policy
Purchase by insured is not a prohibited transaction. Department of Labor exemption (PTE 92-6, amended 8/30/02)
The “fair market value” of a whole life policy where cash value equals reserve value may still be the cash value.
Please note that the purchase of a life insurance policy by the insured is NOT a prohibited transaction provided the conditions of PTE 92-6 are met. The fair market value of a whole life insurance policy has been the subject of recent guidance from the IRS. Participants must rely and consult with their legal/tax advisors on the appropriate measures of the FMV.
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27. Examples of Sale of Policy
412(e)(3) Plan
Plan Transfers Policy
Life Insurance with cash value of $200,000
Fixed Annuity with $350,000 value
Individual Participant
On the sale of the life insurance policy to the individual participant or an irrevocable life insurance trust established by the participant, the 412(e)(3) plan will transfer the policy in exchange for the fair market value of the life insurance policy (in our example the $200,000).
$200,000
Cash transferred to Plan
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28. This plan can be rolled-over or used to provide monthly income
After Sale of Policy
412(e)(3) Plan
Individual
Fixed Annuity with $550,000
Life Policy with $200,000 of cash value
This plan can be rolled-over or used to provide monthly income
After the sale of the life insurance policy the 412(e)(3) plan will be left with the fixed annuity that has a total of $550,000 (which represents the $200,000 in cash paid for the life insurance and the $350,000 annuity amount). The plan values can be rolled over into an IRA or other qualified plan on behalf of the participant or can be used to provide retirement income in accordance with the terms of the plan document. Note that the individual now also has a life insurance policy with a cash value of $200,000 and that cash value can be used for supplemental retirement benefits and of course, support valuable life insurance benefits.
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29. Example of Life Policy Distribution
Assume a $1,000,000 face amount Whole Life Legacy 65 policy distributed to participant with a cash value of $711,292.
Assume a loan and dividend withdrawal of $284,517 to pay Federal and State taxes.
This slide represents the assumptions for the examples that follow. (Unisex Age 52, Select Preferred Non Tobacco, Whole Life Legacy 65) 40% Tax Bracket
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30. Performance of Policy After Loan to Pay Income Taxes
Based on previous assumptions, current dividends and
policy loan interest of 6%, the policy will have the
following values:
Age
Net Cash Value
Net Death Benefit 80
$954,335
$1,500,753 90
$1,401,840
$1,818,863
100
$1,825,180
Based on the life policy illustration, this slide represents the net policy cash values and death benefit after taking a policy loan to pay the taxes on a distribution of the policy. The values provided are non-guaranteed, using current dividend assumptions.
The following examples are all based on the current rates of the MassMutual Odysseysm Annuity and Pension Whole Life Legacy 65 (paid-up at 65) which are not guaranteed. The Guarantees are subject to the claims-paying ability of the issuing companies.
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31. IRS Guidance-Impacting 412(e)(3) Plans Issued February 13, 2004
Rev. Ruling
Rev. Ruling
Proposed Regulation (Reg )
Revenue Procedure
In February 2004 the Internal Revenue Service issued two revenue rulings, a proposed regulation, and a revenue procedure that clarified the limits on 412(e)(3) plans using life insurance in addition to annuity contracts to fund the retirement benefits. The rulings also dealt with the discriminatory requirement of Highly Compensated Employees and the deductibility of contributions for the employer.
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32. Revenue Ruling 2004-20 Two (2) Fact Patterns Deemed Abusive:
Funding of Contracts is greater than plan benefits through normal retirement age
Life insurance contract in plan in excess of death benefit provided by plan
In Revenue Ruling the Internal Revenue Service gave two fact patterns where a qualified pension plan CAN NOT be a section 412(e)(3) plan if the plan holds life insurance contracts and annuity contracts for the benefit of a participant that provide for benefits at normal retirement age in excess of the participant’s benefit at normal retirement age under the terms of the plan. The ruling also addressed when certain employer contributions are deductible. The two fact patterns focus on (i) abusive funding of contracts that are greater than plan benefits through normal retirement age and (ii) abusive life insurance contracts in a plan that is in excess of death benefits provided by the plan.
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33. Revenue Ruling 2004-20 (Cont’d) Fact Pattern 1
The first fact pattern simply and clearly holds that the plan will not qualify as a 412(e)(3) Plan. The funding must be assumed level through normal retirement and not five (5) years or other arbitrary time period
With regard to the first fact pattern in Revenue Ruling the Internal Revenue Service held that a plan will not qualify as a 412(e)(3) plan because the participant’s benefit under the plan, payable at normal retirement age, was not equal to the amount provided at normal retirement age. Thus, the plan failed to satisfy the requirements of 412(e)(3) in order to qualify as a true 412(e)(3) plan. Such failure subjects the plan to the requirements of IRC 412, with charges and credits to the funding standard account determined using the reasonable funding method selected for the plan under general applicable rules (i.e. using reasonable actuarial assumptions).
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34. Revenue Ruling 2004-20 (Cont’d) Fact Pattern 2
Cost of life insurance owned by plan in excess of plan death benefit is non-deductible
Measure of deductible amount is total premiums less cost of “excess” life insurance protection based on “Split Dollar guidelines”
In the second fact pattern to Revenue Ruling , the Internal Revenue Service determined that even if a life insurance contract on the life of a participant provides for a death benefit in excess of the plan described in IRC 412(e)(3) (and would thus fail to satisfy the incidental benefit rules of regulation (b)(1)(i)), if the death benefit is NOT PAYABLE to the participant’s beneficiary, but is instead payable to the plan itself, the plan will still satisfy the incidental death benefit rules.
However, the portion of the employer’s plan contributions attributable to the purchase of life insurance coverage that is in excess of the incidental death benefit payable to the participant’s beneficiaries does not constitute normal cost, and is NOT deductible for the tax year in which contributed. Rather, that portion of the employer’s contribution is used to provide a source of funds to pay future premiums that will come due after the death of the participant. Therefore, the cost of life insurance owned by a plan in excess of plan death benefits is non-deductible and the measure of deductible amounts is the total premiums less cost of “excess” life insurance protection based on (split-dollar guidelines).
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35. Revenue Ruling 2004-20 (Cont’d) Fact Pattern 2
Non-deductible contributions subject to excess tax of Sec (10% per year)
Plans in which excess death benefit exceeds $100,000 are “listed transactions” under Treas. Reg (b)(2).
IRC 4972 imposes an excise tax on employers (other than governmental and certain tax-exempt employers) equal to 10% of the nondeductible contributions made to a qualified employer plan. A qualified employer plan generally means any plan meeting the requirements of IRC 401(a) that includes a trust exempt from tax under IRC 501(a), any annuity plan described in IRC 403(a), any simplified employee pension within the meaning of IRC 408(k), and any simple retirement account (within the meaning of IRC 408(p).
For a tax-exempt employer to be exempt from the tax imposed by IRC 4972, the employer must have at all times been exempt from tax under subtitle A of the Internal Revenue Code and not have received any tax benefit from the plan. When paying the tax imposed under IRC 4972, the appropriate form to file is Form 5330.
Also, transactions that are the same as, or substantialy similar to, the transaction in Fact Pattern 2, will be identified as “listed transactions” for purposes of regulations (b)(2), provided that the employer has deducted amounts used to pay premiums on a life insurance contract for a participant with a death benefit under the contract that exceeds the participant’s death benefit under the plan by more than $100,000.
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36. TD 9223 Final Regulations
Final regulations clarify that when a life insurance contract is distributed from a qualified plan, the policy's fair market value (i.e., policy's cash value plus the value of all rights under the contract, including any supplemental agreements thereto and whether or not guaranteed) is generally included in the distributee's income, and not merely the entire cash value of the contract.
Little guidance on definition of Fair Market Value
Fair Market Value in excess of amount paid is a Plan distribution, and could in certain circumstances disqualify the plan
Final regulations clarify that a life insurance contract distributed from a qualified plan, the policy's fair market value (i.e., the policy's cash value plus the value of all rights under the contract, including any supplemental agreements thereto and whether or not guaranteed) is generally included in the distributee's income, and not merely the entire cash value of the contract.
In Rev. Proc , the IRS provided safe harbor valuation guidelines regarding the distribution of a universal life type policy from a qualified plan. Unfortunately, the IRS has not added much to our knowledge of how to value a whole life type of insurance contract.
Fair Market Value in excess of amount paid is a Plan distribution, and could in certain circumstances disqualify the plan
The proposed regulations contain proposed amendments to the Income Tax Regulations under IRC 402(a), relating to the amount includible in a distributee’s income when a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection is distributed by a retirement plan qualified under section 401(a) of the IRC. The proposed regulations have been supplemented by the IRS in Notice
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37. Revenue Ruling
Discrimination in life policies offered will violate 401(a) and disqualify plan
Applies to any rights, benefits or features
In Revenue Ruling the Internal Revenue Service opined that a plan that is funded, in whole or in part, with life insurance contracts does not satisfy the requirements under IRC 401(a)(4) prohibiting discrimination in favor of highly compensated employees where: (i) the plan permits highly compensated employees (prior to distribution of retirement benefits) to purchase those life insurance contracts prior to distribution; and (ii) any rights under the plan for non-highly compensated employees to purchase life insurance contracts from the plan prior to distribution of retirement benefits are not of inherently equal or greater value than the purchase rights of highly compensated employees.
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38. Does GATT Effect 412(e)(3) Plans?
The Retirement Protection Act of 1994 (a part of the GATT Legislation) limited the maximum lump sum payable with its own specified interest rate and mortality.
Under most circumstances the “GATT” rate will result in a reduction of maximum amount that can be paid in the form of a lump sum.
A potential problem with 412(e)(3) plans is the GATT limit. The GATT limit is a limit on the amount of lump sum distributions. Now I want to emphasize that it only applies to lump sum distributions. If a 412(e)(3) plan is properly funded and administered, and the participant is paid an annuity, this GATT limit does not apply. But, some people may want to take a lump sum distribution from a plan, or rollover the funds into an IRA. If the GATT limit applies and we are terminating a plan or doing a lump sum distribution or rollover, the plan administrator must coordinate the amounts in the plan with the GATT limits. This often means there would be too much money in the plan if it is funded on a maximum basis or for an earlier retirement age.
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39. Overfunding
The practical effect of this is that a §412(e)(3) plan may become overfunded.
If a termination occurs when the plan is overfunded, the excess assets are taxable to the employer and the plan could face tax penalties of as much as 50%.
The practical effect is that most 412(e)(3) plans will become overfunded for purposes of taking a lump sum distribution (and many of the key people/owners of sponsors of 412(e)(3) plans may want to take a lump sum distribution). So, it is an important limit to keep in mind. If the termination or the distribution takes place while the plan is overfunded to the extent of the overfunding the distribution will be taxable income to the employer with an excise tax of up to 50 percent. This is not a good thing. Any disposition, other than accepting the guaranteed annuity upon which the 412(e)(3) plan is being funded, is going to be analyzed as a lump sum distribution. Even if you annuitize under another annuity that will be analyzed as a lump sum distribution. If lump sum distributions are taken by the key people and rolled over into IRAs are overfunded, there will be subject income tax to the employer plus an excise tax.
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40. Strategies to Avoid Overfunding
After the 412(e)(3) plan has been in effect for several years, the plan can be converted to a “regular” defined benefit plan.
This will mean having an enrolled actuary and complying with the funding limitations.
So, what can be done to prevent this overfunding problem? There are several strategies that can be utilized. This is a good place to point out the importance of having a third-party administrator who understands defined benefit plans and also understands specifically the 412(e)(3) plans. The administrator of the plan should help educate the business owner as to what can be done.  A good TPA is critical to ensure that the plan is not discriminatory, that all IRS and Dept. of Labor rules are followed, and that issues such as the GATT limitation are adequately planned for.
One strategy to avoid termination (while there is an overfunding) is to fund the 412(e)(3) plan for several years then convert to a regular defined benefit plan. An enrolled actuary will then be required; the actuary will likely determine that the plan is over-funded based on reasonable actuarial assumptions. Contributions at that point may be decreased or eliminated for a period of time until the plan gradually comes back into line so it is not overfunded for purposes of taking a lump sum distribution.
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41. Strategies to Avoid Overfunding
The plan post conversion will probably be “overfunded” and should come back in line with funding limits as years pass without contributions being made.
Fund to less than the maximum allowable benefit. If funded to 65% of maximum benefit the plan may avoid overfunding for lump sum distribution purposes.
Fund to age 65 and freeze Plan prior to age 65.
A second strategy is to fund for less than the maximum benefit because the GATT limit is on the maximum benefit calculation. So if we fund to 65%, for example, of the maximum benefit (say $126,750 instead of the maximum benefit being $195,000(2009) a year) we may very well have a plan that may never become overfunded for GATT purposes. Even if overfunding still occurs, using a benefit less than the maximum, the overfunding will be reduced. This is something that the administrator should carefully watch. A third alternative is to fund each year as if GATT applies. Basically you have reduced your funding a little bit each year as you go along. It is a little bit more complicated but some administrators are very comfortable with this approach because it takes care of the problem as you go along.
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42. Consider a Traditional DB Plan as an Alternative
The Plan can still have life insurance.
No overfunding issues.
Assets not limited to fixed annuities and life insurance.
Life insurance for practical reasons limited to 100x the monthly benefit
Traditional DB Contribution Comparison
Participant’s Age 52
412(e)(3) Plan*
Traditional DB Plan**
Profit Sharing Plan
1st Year Contribution
$138,307.83
$43,380
N/A
Maximum Contribution
$49,000(2009)
Another alternative is to simply consider using a traditional defined benefit plan and not a 412(e)(3) plan. Under a traditional defined benefit plan life insurance can still be used, you will not have to worry about GATT since you are limited to the contributions you can make (therefore no over funding issues), assets will not be limited to fixed annuities and life insurance, and life insurance is limited to 100x’s the monthly benefit.
*Assumes a life insurance/annuity combination limited by ; a normal retirement age of 65 and an anticipated
monthly benefit of $10,000
**Assumes a 6% accumulation.
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43. “Carve Out Plans”
In general, Carve Out Plans are two separate plans established by the same employer/sponsor. Often one is a defined benefit plan and one is a defined contribution plan.
The challenge for most employers is that a 401(k) plan is great, but not enough can be put away for the top executives. Conversely, a 412(e)(3) plan can benefit the executives, but the plan may require too much to be deposited for the rank and file employees. The solution is a Carve-Out plan that offers combination of a 401(k) and 412(e)(3) plan. The plan could potentially provide for a base 401(k) plan contribution up to the maximum to the rank and file employees, while “carving out” a special 412(e)(3) plan for the highly paid employees. A 412(e)(3) carve-out plan can be established, which would provide a required employer contribution to the maximum salary contribution going into the 401(k) plan for most of the employees and a 412(e)(3) for the executives, therefore, as much as 90% of the total qualified plan contribution could go to the owners. In addition, the contribution to the owner’s account may exceed the net after tax cost of the plan.
This is a complicated area of pension law as you will see from the formulas on the following slides. A competent TPA is required to provide the necessary testing.
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44. Both Plans Must Pass Minimum Coverage Requirements of IRC Sec. 410(b)
Ratio Percentage Test:
The plan benefits at least 70% of employees who are not highly compensated (“NHCE”); or
The plan benefits a percentage of NHCE that is at least 70% of the percentage of Highly Compensated Employees (“HCE”) benefiting under the plan
Average Benefits Test:
Three part test
Complex
In general, a plan is not a qualified plan (and a trust forming a part of the plan is not a qualified trust) unless the plan satisfies section 410(b)(1). A plan satisfies the requirements of this subparagraph if it benefits at least: (i) Seventy percent or more of “all” non-highly compensated employees in the company, OR (ii) the plan benefits a percentage of non-highly compensated employees that is at least Seventy percent of the percentage of highly compensated employees who are benefited under the plan. Examples of how this works will be provided in the following slides.
The percentage requirements of this 410(b) refer to a percentage of active employees, including employees temporarily on leave, such as those in the Armed Forces of the United States, if such employees are eligible under the plan.
Classification test. A plan satisfies the requirements of section 410(b)(1) if it benefits such employees as qualify under a classification of employees set up by the employer, which classification is found by the Internal Revenue Service not to be discriminatory in favor of employees who are officers, shareholders, or highly compensated. For purposes of 410(b), all active employees (including employees who do not satisfy the minimum age or service requirements of the plan) are taken into account.
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45. Examples of Ratio Benefits Tests
70% test IRC §410(b) (1) (A)
10 employees,
2 HCEs,
8 NHCEs
Plan must benefit 70% of NHCEs under this test
70% x 8 = 5.6 – Plan must benefit at least 6 NHCEs
In this example we have a total of 10 employees (2 of which are Highly Compensated employees) under Internal Revenue Code 410(b) the plan must benefit at least 70 % of the “Non-Highly” compensated employees. That would be: 70% multiplied by the number of “non-highly” compensated employees, which equals 5.6 people. Rounded up, the total number of “non-highly” compensated employees that the plan must cover to qualify is 6.
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46. Examples of Ratio Benefits Test
The relative percentage test-IRC §410(b) (1) (B)
15 eligible employees,
2 HCEs
13 NHCEs
Assume only 1 HCE participates in plan (50% of HCEs)
Plan must benefit 70% of 50% of NHCEs
70% of 50% = 35%
Plan must cover 5 NHCEs employees
Next is an example of the relative percentage test under 410(b)(1)(B). We start with 15 eligible employees, two of which are Highly Compensated. What has changed here is that only one of the Highly Compensated participates in the plan. Since only half of the highly compensated employees is participating then under 419(b)(1)(B) the plan must benefit 70% of 50% of the Non-Highly Compensated Employees. As the example shows (70% multiplied by 50% equals 35%) the 35% determines the amount of Non-Highly Compensated employees that must be covered in order for the plan to qualify (35% multiplied by 13 employees equals 4.55 people). The plan, therefore, must cover 5 of the “Non-Highly Compensated Employees”.
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47. Additional Participation Requirement for Defined Benefit Plan
In addition to coverage tests outlined above, defined benefit plans including 412(e)(3) plans must meet the requirements of IRC §401(a) (26) that provides that a defined benefit plan must cover the lesser of 50 employees or 40% of all employees.
Under IRC 401(a)(26) in order for a 412(e)(3) plan to qualify as a defined benefit plan the plan must cover at least the lesser of (i) 50 employees (not 50 %) of the employer or (ii) the greater of (I) 40% of all employees of the employer, or (II) 2 employees (or if there is only 1 employee, such employee). Another way of stating it is that the plan satisfies the requirements for a plan year only if the plan benefits at least the lesser of: 50 employees of the employer or 40% of the employees of the employer.
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48. Hurdles to Overcome for “Carve Out” Plans
Both plans must meet coverage tests under IRC §410 (b)
Sponsor must have a non-discriminatory or have “business reason” for dividing participants between the plans
The defined benefit/412(e)(3) plan must pass IRC §401 (a) (26) test (typically cover 40% of all employees)
As mentioned above, 410(b) requires that all plans cover at least Seventy percent or more of “all” employees in the company or (ii) Eighty percent or more of “all” employees who are eligible to benefit under the plan. Also, a sponsor of a crave out plan MUST have a non-discriminatory or “business reason for dividing employees between the two plans.
With regard to Discrimination: the determination as to whether a plan discriminates in favor of employees who are officers, shareholders, or highly compensated is made on the basis of the facts and circumstances of each case, allowing a reasonable difference between the ratio of such employees benefited by the plan to all such employees of the employer and the ratio of the employees (other than officers, shareholders, or highly compensated) of the employer benefited by the plan to all employees (other than officers, shareholders, or highly compensated). A showing that a specified percentage of employees covered by a plan are not officers, shareholders, or highly compensated, is not in itself sufficient to establish that the plan does not discriminate in favor of employees who are officers, shareholders, or highly compensated.
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49. ©2009 Massachusetts Mutual Life Insurance Company, Springfield, MA
©2009 Massachusetts Mutual Life Insurance Company, Springfield, MA. All rights reserved. MassMutual Financial Group is a marketing name for Massachusetts Mutual Life Insurance Company (MassMutual) and its affiliated companies and sales representatives