412(i) plans

[Lori H]

Would a 412(i) be a good option for an owner, age 45, who is currently earning $600,000 annually, but whose income level will be tapering off over the next five years?

[david rigby]

Such a temptation to simply say NO!

However, the proper response is "what is he/she trying to accomplish?"

[Mike Preston]

Actually, I'd say the "tapering off" part does argue for a 412(i). What level will it taper off to?

[Lori H]

Thank you for your responses. To answer your questions:

1. He is trying to shelter as much income as possible.

2. In five years the income will be $0.00.

To add to the original question - If a 412(i) is not a good idea would a traditional DB plan work?

[david rigby]

A 412(i) plan will "shelter" more than a traditional funding arrangement, but what really counts is what the employee gets out of it. Just because the upfront annual deposits are higher does not mean the payout is higher.

[mwyatt]

I agree with Pax. Unfortunately, I think that we may be on the crest of favorable pension legislation at the moment. I wouldn't want to be the one setting up that "136,425 at 55 plan ala 1981" right now with a disastrous outcome in a few years when your client wants to actually see some of that hard-earned money that they put into the plan. Keep a little off the table; at some point the government is going to come around again lookin' fer revnue...

[Mike Preston]

Keeping money off the table is fundamentally inconsistent with a 412i arrangement. I presume you meant unfavorable.

[AndyH]

Mike, do you think this is a good idea? If so, what would you suggest be done in year 6?

[Mike Preston]

I would have to see the numbers, as not all 412i programs are created equal, before I could say one way or the other about it being a good idea or not. But, if:

1) by the end of the 5th year the individual will have established a high 3 year average that supports a distribution in year 10 of the value expected to accumulate in the product at year 10 after switching from 412i to non-412i in year 6;

2) if the employer is able to maintain some sort of operation such that service can be credited for years 6 through 10;

3) if the client is happy with the internal rates of return that would be generated at that time (this isn't too tough in today's economic environment - it was much tougher two or three years ago);

4) if the client understands the risks involved in seeing interest rates rise such that 415 lump sums are restricted;

5) or, in the alternative to 4 is willing to accept an annuity distribution for life from the insurance company equal to the contract guarantees (this is an annuity product, after all)

6) if the client, and maybe the client's estate planning attorney, understand the consequences of death before cessation of the 412i program (through year 5);

7) if the client, and maybe the client's estate planning attorney, understand the consequences of death in the 6th through 10th years

8) if the client understands the consequences of shutting down the program and distributing the assets while the relatively large investment penalties are in place, including a shut down brought about by legislative or regulatory changes

9) if the client understands the costs associated with maintaining the program in the face of additional staff;

10) [reserved for something else that isn't popping into my head at the moment, but you get the drift]

then I would have no problem recommending such a program.

As you can see, it is a somewhat unusual set of circumstances where such a program really makes sense from my perspective.

I have had many inquiries regarding 412i programs. I've only had 2 clients ask me to help them fully understand the ramifications of the suggested program. One decided things were too speculative for him to enter into it. The other one was fully informed before she went forward with the program.

[AndyH]

Thank you. Even more insightful than I expected. How about 10 being if the client understood the rating of the insurer and the risk that the insurer might become insolvent at some point.

Somebody told me that the insurers offering these things tend to have lower ratings. Anybody know if that is true or not?

[Guest DOM]

I think PAX makes a valid point in regard to the important thing being how much the employee takes from the plan not how much was put in. And in most all situations where life insurance is being used over this short period, there will probably be a negative, however, if all annuity is used with favorable provisions for employee termination {not plan termination} the scenario presented should look pretty good.

mwyatt, makes a valid point about future legislation at least to the extent that we and our clients will always be at risk of negative legislation. but if we should buy into that thinking it would mean that we shouldn't be doing any type of DB plan. Or am I missing the point?

[AndyH]

Certainly one point is that the IRS has recently stated (1/31/03) that they were giving "very high priority" to providing guidance on abusive 412(i) plans, and would "not be gentle" and also used the word "criminal" within this context.

Other phrases used were "of paramount importance". They are considering issuing a warning to practitioners, then something more substantive to follow.

Lori Hughes, unless you can answer Mike's 10 point plan, you might consider sticking to a traditional db plan. Although year 6 is still a concern, it sounds like there will be sufficient legitimate business reasons to terminate it at that time.

Plus, investing in the stock market now may be the best "springing cash value" available within a 6 year time horizon!

[mwyatt]

Actually with a traditional DB plan, you would presumably not be funding for a benefit at retirement using post-retirement assumptions well in excess of what you could pay out as a lump sum using 94GAR and a best case rate of 5%. You would also probably be recognizing the likelihood of ultimate payment as a lump sum, so you wouldn't be funding for 100J&S form of payment to develop a larger contribution. So yes, your deductions would undoubtedly be lower than would develop under a 412(i), but you wouldn't be setting yourself up to create a horribly overfunded plan. Even if pension law stays the same, a 412(i) funding for the subsidized 100%J&S payment with an extremely low interest rate is going to create an overfunded situation, unless your client wants to accept payment in an annuity form (see Mike Preston's points). A traditional DB plan, through FFL applications and more realistic assumptions, would most likely not put you in such an overfunded state.

One other thing: the 30-year rate at some point is going to be replaced and the 415/417 interest rate will undoubtedly be heading higher. The level of overfunding could explode if this rate heads back up to the 8% levels we were at when GATT was originally put in place, making the situation that much worse. A regular DB plan could adjust to rising interest rates much easier than a fixed contract at 3.5%. Sure you get the deduction, but it's kind of fool's gold if you don't get to see the money back at the end.

[Mike Preston]

Aw, you are such a spoil sport. (g)

[Guest merlin]

Andy,

Where does the IRS statement appear?

[AndyH]

BNA 2/4/2003. I'm surprised that Benefits Link did not have a link to the comments, which were at the LA Benefits Conference. Maybe somebody here attended that? It was apparently a panel on "aggressive tax practices". Maybe somebody can find a story online.

[Lori H]

Thanks again, for your responses. I understand the possible dynamic future of 412(i)'s and the need to CYA, but here are some more facts:

1. The business has two employees, the owner (age 45) and

his wife.

2. The owner is the only one drawing income. For the next

five years, he estimates that income to be as follows:

Year #1 = $160,000

#2 = $350,000

#3 - #5 = $60,000 per year

After year 5 he doesn't know what income, if any, will be generated. The agent wants to park the money in annuities only. The owner is also a participant in a 401(k) Safe Harbor. I'm leaning towards a traditional DB. However, the agent is not yet ready to rule out a 412(i).

[AndyH]

There is not a sustained revenue stream sufficient to justify a db plan of any type, IMO. This is a profit sharing plan candidate only.

[Mike Preston]

I don't think there is anything to add to the discussion. You just need to have the numbers compared and see whether there is an advantage. And, if there is, if the risks are worth it.

But I will comment on one thing, since it is a Friday afternoon and I guess I'm in a rotten mood. We frequently get statements from clients that make our life more difficult. One of them is hearing that income is $600,000 and then hearing that it is $160,000. I know you were probably going on the best information available, but it is still deflating at times.

[Mike Preston]

Andy, I think there is not nearly enough information to make the determination. Past salary history, cash flow needs, future employee projections. A db, even a 412(i), might make sense. But without more information than it really makes sense to share in these forums, I can't say one way or the other.

[mwyatt]

Could you clarify a bit the "401(k) safe harbor"? With another entity by any chance? Just on the side, a little curious why an entity that only employs the husband and wife had to resort to a safe harbor plan design (and this question pertains to any type of db implementation - something sounds a little odd here and presumably the SH match/discretionary will run afoul of IRC 404 if you put in any type of DB if not shut down properly). I'm assuming also that your "salary" projections cover both income and contribution. Unfortunately, most of the 412(i) illustrations assumes daddy warbucks as the plan sponsor (witness the past thread with the $300k deduction for a 35 year old).

[Guest DOM]

In regard to Andy's question about the solvency of insurers touting 412i plans. I ran through 10 companies that I know are in this business. 2 are A++, 3 A+ and 5 A.

[AndyH]

Mike, yes, you are right (what a shock). I was expressing my conservative opinion on setting these up and should have specified that.

I automatically set as a criteria the requirement that a client commit to funding it for at least 5 years, and this looked iffy on that criteria. But a DB could work at a scaled down deduction level with some careful planning and, more importantly, effective communication.

And thanks, Dom. I know of only one company and there is no reference to 412(i) on their website. And yes, I'm sure there are many others. But it's funny how the larger companies have no references to them on their websites, either. That could of course simply be due to a lack of volume.

[mwyatt]

Actually, the solvency issue is something to consider (having had my dad go through the Executive Life fiasco in the 80s while at Honeywell). By sheer observation, all your eggs are in one basket with a 412(i) plan, whereas a traditional DB plan would (hopefully) have assets relatively diversified... These companies are rated highly now, but times do change.

[Lori H]

The 401(k) Safe Harbor is for another entity.

As for the questions raised by Andy:

There is no past salary history.

The is not a cash flow need.

and

There will be no other employees.

[mwyatt]

Can we clarify one point here? Are the incomes you previously cited (160k year 1, 350k year 2, 60k 3-5)

1) total revenue of this entity (i.e., are these amount going to comprise salary or net income if unincorporated PLUS the contribution), or

2) are these salary figures with the contribution figures coming from some other source.

This is important as if this is case 1 combined with your statement that there is no past salary history, your situation could be even worse since the 415 $ limit may be academic; you may be more constrained by the High 3 Year comp average. I really don't think you've got the funds available to contemplate a 412(i) (you just have one big projected year 2 and then everything dwindles down to nominal amounts).