DEFINED BENEFIT PLANS

Only qualified retirement plan to provide employees with a guaranteed retirement benefit payable at normal retirement age, with reduced benefits payable at an earlier retirement date.

Benefit is usually a monthly benefit based on compensation and years of service, and payable for the lifetime of the participant.

Plans may allow for "cash out" at retirement, with participant receiving a single lump sum instead of monthly payments.

Employer has obligation to make necessary contributions. Premiums may be paid to the Pension Benefit Guaranty Corporation to insure the benefits.

A 412 plan is a defined benefit retirement plan whose funding requirements fall under Internal Revenue Code Section 412. If a plan meets the requirements of this subsection, it is exempt from the complex funding rules of Section 412 of the IRC applicable to all other defined benefit plans.

Since the passage of the Tax Reform Act of 1986 and the Omnibus Budget Reconciliation Act of 1987, the small business owner has lost interest in defined benefit plans.

A "fully insured" Defined Benefit plans provides an attractive alternative solution offering simplicity, maximum current tax-deductible contributions and guaranteed retirement benefits.

A "fully insured" plan can provide substantial retirement benefits under this simple and secure program. The accrued benefit for participants is simply the cash surrender value of all insurance contracts. It provides a maximum current tax deductible contribution for the business. Some of its other advantages include:

• No full-funding limitation under ERISA Section 404(a)(1)(A) or current liability test to limit contributions.
• There can be no over-funding.
• There can be no under-funding. Contributions are based solely on the guaranteed provision of the level premium contracts.
• No actuarial certification required.
• Substantial administrative savings through the use of an IRS-approved prototype. Wealth Preservation Strategies can advise on special programs available for very reasonable administrative fees.
• No quarterly contributions are required, unlike a traditional defined benefit plan; the "fully insured" model may be funded annually without having to pay interest.
• The IRS will not challenge the plan assumptions, thus permitting higher deductions. It is the contract guarantees that govern the required contributions.

The Defined Benefit plan may not be the ideal plan for all situations and businesses. Given the large, required contributions that must be made each year, it works only when the business is established and highly profitable. It works best when there are very few employees (less than five); and where the owner is fifty years old or within 10 years of retirement and is older than any of the firm's employees. In brief, its disadvantages include:

• No policy loans can be outstanding at year end. This is not normally an issue, as many owners of a small business cannot normally participate in any retirement plan loan program.
• No flexibility in investments. The plan must be funded exclusively through insurance contracts in order for all benefits to be guaranteed.

When compared with other types of defined benefit plans, larger current contributions are created with a 412 plan. Life insurance and annuity guaranteed assumptions are conservative. A Traditional Defined Benefit Plan will have an interest rate assumption much higher than the guaranteed interest rate in a "fully insured" plan. The lower the plan assumptions, the higher the required contribution. It's that simple.

It can be expected that some insurance contracts may earn interest above the guaranteed rate. Dividends may be paid on "participating" life insurance contracts. Both dividends and interest in excess of the guaranteed rate will decrease the employer's contribution in a following year. It should be noted that life insurance dividends for all defined benefit plans must be used to reduce the premium.

Such gains will tend to increase over time, essentially lowering the cost of the 412 plan. Hence, if all else remains unchanged, the "fully insured" plan's tax-deductible contributions will be greater in the early years. In contrast, due to limitations imposed by the Omnibus Budget Reconciliation Act of 1987 (OBRA), the funding costs for traditional defined benefit plans will often tend to increase over time.

A 412 plan needs no actuarial certification, as only enough money to provide the guaranteed benefits can be paid to the plan. There can be no over-funding or under-funding problems. This is simple, too.

A "fully insured" plan is subject to the same maximum benefit limitations and "top heavy" provisions as a traditional defined benefit plan. Let's examine each of these in greater detail.

Top heavy rules are simplified:

1. 5-year lookback to determine key employees modified to a 1-year testing period (data for 4 preceding years ignored);
2. Compensation used to determine officers is increased to $130,000 (subject to cost of living adjustments, in $5,000 multiples, starting in 2003);
3. Top 10 employee test eliminated.
4. Matching contributions will now count toward satisfying the top heavy minimum contribution requirement and are still counted in the ACP test;
5. 1-year look back instead of 5-year look back applies for adding prior distributions made after termination of service or plan termination;
6. Safe harbor 401(k) and 401(m) plans are exempt from the top heavy rules;
7. Top heavy minimum accruals are not required under a frozen defined benefit plan.

Taxstrategy.com provides solutions to this problem through plan design, selecting benefit formulas that are much higher than the minimum top heavy requirements.

The ERISA section that limits the overall plan benefit is known as the "415 limit." Section 415 applies to all defined benefit plans in the same way. It dictates the maximum retirement benefit. Currently, this provision limits a defined benefit plan to a maximum of $160,000 of annual income. This amount is reduced if the actual retirement age is less than Social Security retirement age.


Taxstratetgy.com sometimes suggests minimizing this lump-sum distribution problem by using a plan designed to initially be below the Section 415 limit, with the expectation that the lump sum will be rolled out of the plan into an IRA. Even with this reduced limit, the "fully insured" plan provides a much larger current deduction when compared to a traditional defined benefit plan.

To maximize the available benefits of a Defined Benefit plan, an option to purchase life insurance under the plan may provide up to one half of the plan retirement benefits. The guaranteed cash values and guaranteed premiums of the suggested whole life insurance contracts are ideal for funding such a "fully insured" plan.



While life insurance does not need to be offered under a 412 plan, this feature does provide important additional benefits for a participant. If there is an insurance need, the participants may obtain the benefits of life insurance on a pre-tax basis. For highly profitable, closely held businesses, there often exists a substantial insurance need for the owner. A "fully insured" plan cannot only maximize the current deductions, but can also meet these needs by funding the benefit with life insurance contracts.

When life insurance is included inside a pension plan, the participants must recognize as a taxable cost the "current economic benefit" provided by the plan (IRC Section 72(m)3(B), Reg. Section 1.72-16(b)). Each participant is then taxed currently on the cost of the "pure" life insurance benefit. The cost of this current benefit is known as the P.S.58 cost. The cost is determined by using the one-year term rates published in Rev. Rul. 55-747. if, however, the insurance company's one-year term rates are lower, the participant may use the insurer's lower rate to determine the amount to be included in gross income (Rev. Rul.66-110, 1966-1 CB 12).

Taxstrategy.com can provide policies with very competitive one-year term rates. For example, the initial year's taxable income for a $1,000,000 face amount for a 50-year-old is:

Using the Government's P.S.58 Rates $9,220

Using WPS suggested Taxable Term Rates $1,020

Retirement Age: 65
Amount of Tax Deduction

Retirement Age: 60
Amount of Tax Deduction

Retirement Age: 55
Amount of Tax Deduction

^*Lump sum payments under defined benefit plans after 1994 are limited by the provisions of the GATT bill.
This illustration limits benefits to show lump sum payments which might become payable.
These figures are based on NL Advantage Gold whole life insurance (Policy #6597), UNISEX, non-smoker rates and Life of the Southwest Equity Indexed Annuity (Policy #7691) annuity contracts. Insurance contracts are underwritten by National Life Insurance Company, Montpelier, Vermont. These products may not be available in all states.

A 412 plan is simple and may perhaps be the ideal plan for the owner of a small business or professional enterprise who desires to maximize his or her current tax deduction and secure guaranteed retirement income. The contributions are, by design, quite large in the early years of the plan and may be less appealing as the number of plan participants increases. Introducing life insurance to fund a portion of the benefit will provide increased initial contributions and a current pre-tax life insurance benefit for each participant.

Taxstrategy.com provides "fully insured" plans that are unique tax reduction tools for today's small business owner.