Is a defined benefit retirement plan right for you?

Success in business can bring some pretty wonderful rewards, including the ability to finally start stashing money away for retirement. Unfortunately, it can also bring high income tax rates, pension contribution limitations, and the potential for estate taxation. Combined with today’s unpredictable investment environment, this might help explain why more and more successful business owners and professionals are turning away from defined contribution plans such as 401(k) as a means for retirement savings, and showing a renewed interest in defined benefit retirement plans.

Like defined contribution plans, defined benefit plans are a tax-deductible (and tax-deferred) way to save for retirement. But unlike their defined contribution counterparts, which limit the total amount of contributions that can be made to no more than $46,000, and in some cases much less, defined benefit plans can allow you to contribute significantly more. In fact, some defined benefit plans may result in annual contributions of $100,000, $200,000, or more. Throw in substantial income tax deductions, guaranteed benefits and protection from investment market ups and downs and it’s easy to see why defined benefit plans are making a comeback.

But while defined benefit plans generally are beginning to get a second look, one specific type of plan commonly known as a “412(e)(3) Plan” is drawing particular attention. Named for the section of the Internal Revenue Code from which it is taken, 412(e)(3) Plans are unique in the retirement planning arena because, in addition to offering fully guaranteed retirement benefits and the largest possible tax deduction, they are funded not with stocks, bonds, mutual funds, or other similar investments. Rather, they are funded with life insurance and fixed annuity contracts. The accrued benefit for participants at retirement is a stated monthly pension or simply the guaranteed cash values of the underlying policies.

Why all the attention to 412(e)(3) plans?

There are a number of reasons why 412(e)(3) Plans are becoming so appealing. Business owners and professionals appreciate the ability to set aside large amounts of money each year, while taking large tax deductions for doing so, as well as the fully guaranteed retirement benefits they provide. (All guarantees are based upon the claims-paying ability of the issuer.) Employers find 412(e)(3) Plans so attractive because they avoid the complications commonly associated with traditional defined benefit plans. For example, no enrolled actuary’s certification is needed; there are no required quarterly contributions; there is no full funding limitation applied that might limit contributions; and administrative costs are generally lower. Other popular features of 412(e)(3) Plans include:

-The life insurance component. If life insurance is included as part of the plan, the death benefit in excess of the cash value of the policy is paid to the beneficiary income tax-free – a self-completing savings feature that can be very attractive to small business owners and self employed individuals.

-Protection of plan assets from lawsuits and creditors.

Who qualifies for a 412(e)(3) plan?

By and large, 412(e)(3) Plans are ideal for business owners with relatively few employees who can commit to making large, regular contributions. They are equally suited to successful self-employed individuals who may have been unable to set money aside for retirement in their early years due to family or other obligations, and who now need to put away large amounts of money in a short amount of time. Individuals who are starting a second career are also good candidates for 412(e)(3) Plans, as are people who want to provide for family members and/or heirs should they die prematurely.

412(e)(3) Plans are not, however, ideal for everyone. The concept works best for businesses that are well-established and highly profitable (especially given the large required contributions that must be made each and every year); where the owner is fifty years old or within 10 years of retirement; and when the owner is older than most of the firm’s other employees.

Disadvantages of a 412(e)(3) plan

There are disadvantages to 412(e)(3) Plans, especially for businesses or individuals who want the option of borrowing from their plan or choosing how their plan assets will be invested. With a 412(e)(3) Plan:

-No policy loans can be outstanding at year-end. (Normally this is not an issue since owners of small businesses generally cannot participate in retirement plan loan programs.)

-There is no flexibility in investments. 412(e)(3) Plans must be funded exclusively with life insurance and/or annuity contracts in order for all benefits to be guaranteed.

So could a 412(e)(3) Plan be right for you or your company? Much depends on how you answer the following questions:

-Have you reached your full funding limit under your existing defined benefit plan?

-Do you need to accumulate large amounts of money for retirement in a short amount of time?

-Can you commit to making large, annual contributions?

-Is it time to play “catch up” with your retirement savings?

-Are you looking for a large annual income tax deduction?

If your answer to any or all of the above is “yes,” a 412(e)(3) Plan may be just what you’re looking for to help secure a comfortable financial future.

This information is for educational purposes and should not be considered specific financial, tax or legal advice. Always consult with a qualified advisor regarding your individual circumstances.

Winfield C. Greenwood, RFC® is the owner/founder of Redstone Financial Group, LLC, an independent financial services firm based in Las Vegas. He shares his expertise on business and personal financial planning with the RJ every week. Contact him at (702) 475-6363,wgreenwood@redstonefg.com, or connect via Facebook or Twitter.