412(i) Plans

[Guest jig100]

Can a self-employed person maintain a 412(i) plan using only insurance as the funding vehicle (as opposed to an annuity)?

[Belgarath]

An interesting question. If you take an extremely literal reading of 412(i), it would seem to at least be arguable that this is possible. However, I do not believe this would pass muster. I sure wouldn't do it without a PLR from the IRS. And a 412(i) funded solely with life insurance is going to have a pretty hefty contribution level, and plan disqualification would have some pretty nasty tax consequences.

In addition, in my opinion, it is utterly ridiculous to fund a plan solely with life insurance (and I'm not anti-life insurance either.)

I don't believe whether one is self-employed or not has any bearing on the answer - if allowable, then it's allowable for a self-employed. I just don't happen to think it's allowable...

[mwyatt]

A little confused; how would pure insurance (a benefit payable at death) provide the benefit provided under a defined benefit plan (an annuity payable for life?).

[Belgarath]

The benefit would be funded by the cash value of the life insurance, which can be annuitized.

[Guest merlin]

The cash value of the policy provides the benefit reserve.Think of it as a split-funded plan taken to the extreme-no auxiliary fund.As long as you don't exceed the 415 maximum lump sum (maybe easier said than done if the policy interest rate is between 3 and 4%) you're all right. But there is more to 412(i) than meets the eye.See the earlier posts on this board regarding 412(i) recordkeeping.There seems to be a resurgence of interest in 412(i) plans-I can't see why. The market segment would seem to be very narrow, and there are a lot of traps for the unwary. But I guess in the right circumstance a 412(i) plan could be appropriate.

[mwyatt]

Assuming that this is normal whole life insurance, I would have to speculate that in order for the CSV to cover the benefit that the face amount of the policy(ies) would be quite large; most likely substantially over 100 times the projected benefit at retirement. How would you reconcile this with the incidental death benefit rule? Also, assuming that your client had the misfortune to die, wouldn't you be basically passing all of the excess onto the IRS as an over funded plan rather than to the beneficiaries?

[Guest merlin]

In my experience most 412(i) are funded using a combination of insurance and annuity policies,with the annuity policies predominating. The guaranteed interest rates in the annuity policies are so low that the conversion factors approach a perpetuity (just kidding , but you get the point), thus producing extermely high premiums. The life policies are just along for the ride,so they will be limited to 100x.Gravy for the agent.

If the principal were to die there are two possible scenarios:

Death in the early years of the plan-probably not overfunded.The cash values are probably only around 40% of the premiums paid. The rest has gone to expenses.Beneficiary not very happy

Death in the later years- yeah, overfunding could be a big problem.The plan should be converted to a conventional db plan at the crossover point-usually year 4 or 5-where the cv's are high enough that the db plan will require little or no contribution, but low enough not to be a 415 problem. Of course if you miss the window and there's only one participant,and he dies...Beneficiary not very happy.

As I said earlier they're a very dicey product and the people who are selling them usually don't have a clue.

[AndyH]

Don't misunderstand; I think these are a very bad idea, but I can see people sucessfully selling db plans that are exempt from the problems of 417(e), restricted payments, and pbgc variable premiums, as they seem to be. So, if these things are true, I can see why there is interest.

[Belgarath]

Merlin - just a couple of observations.

I'm not sure I understand your comments on the first scenario. The beneficiary is receiving the proceeds of a very large life insurance policy. From a strictly monetary point of view, why would they be unhappy?

My problems with 412(i) plans are not philosophical, but practical. Yes, they can work in certain narrow circumstances. But I agree that they are usually marketed by insurance agents who have no clue, other than seeing large dollar signs when they see the commissions. My biggest problem is that almost all the 412(i) plans I have seen are built on a maximum formula. Then at some point during years 2-4, in 20 to 40 per cent of the cases, the client does not have the money to handle such a large contribution, and the excrement hits the windmill. I also have to place some responsibility on the CPA's when discussing 412(i) problems. 412(i) plans are for clients who make pots of money, and ALWAYS have their CPA involved. When we try to point out the potential problems to the CPA's, the CPA's invariably respond with something to the effect of, "We want the deduction this year, and we'll worry about the problems when they happen." Ah well - so my feelings on 412(i) - great in theory, sometimes great in reality, more often not great in reality!

[Guest merlin]

Belagarath,looking at it again I don't understand my first comment either. I must have been confusing death with regular termination.Maybe it was just another "senior moment".Whatever the reason, strike it from the record.

As for your second comment,I find it interesting that you as an actuary are actually getting a chance to comment on the 412i beforehand. Agents usually sell a 412i plan on the basis that an actuary is not needed (read: no fees to anybody but the agent).But it sounds like client and his other advisors are ignoring you anyway,so the end result is the same.it's a greta comfort to know that some things never change.

[Belgarath]

Hi Merlin - just so you know, I'm not an actuary. (But I do sit next to one, and he's a great guy. I'm not sure why there are so many jokes about actuaries - all of them I've met are really interesting people) We're a TPA firm, and probably because we specialize in the small plan market, have close contact with the networks of people who send us business. So although the 412(i) is proposed and the concept is sold generally before we get involved, we're fortunate enough to be in on the process early enough to sometimes help them avoid mistakes. But they usually don't listen, as you so aptly observe. Sigh... on the other hand, I really shouldn't complain, because if everybody did what we told them to, we'd probably put ourselves out of business!

[Guest merlin]

Belgarath-Isn't that an awful catch-22?

[Belgarath]

You bet!