The 401(k) plan is, far and away, the most popular type of qualified retirement plan in the United States. And no wonder: It allows participants to defer earnings of up to $22,500 on a pretax basis in 2023 ($30,000, if you're age 50 or older) and benefit from matching employer contributions. Contributions grow and compound tax-free within participants' accounts until they make withdrawals — typically in retirement.
But there are other retirement plan options that employers might want to consider offering. One alternative, the fully insured defined benefit plan, also known as a 412(e)(3) plan, usually flies under the radar. But this type of plan may be attractive to older small business owners. Let's take a look.
Unlike 401(k)s, which are defined contribution plans, 412(e)(3) plans are defined benefit plans. This means that 412(e)(3) plans provide benefits under a formula based on factors such as the participant's compensation, age and years of service.
For 2023, the annual benefit can't exceed the lesser of:
As with other defined benefit plans, a fully insured 412(e)(3) is funded only by the employer. It doesn't accept any participant contributions.
But unlike other defined benefit plans, which are funded through a variety of investment options, 412(e)(3) plans are funded exclusively with insurance and annuity contracts. Hence, the name "fully insured" defined benefit plan. The plan's other common name — 412(e)(3) plan — comes from the tax code section authorizing its use. (In the past, this plan was described under Section 412(i) of the tax code, so the plans used to be called 412(i) plans.)
Under Sec. 412(e)(3), defined benefit plans that are funded exclusively with insurance and annuity contracts aren't subject to the minimum funding requirements — so long as conditions are met. Employers don't have to make annual actuarial calculations or mandatory contributions. However, you risk penalties if your plan's insurer or annuity provider doesn't satisfy certain obligations. In other words, the plan needs to be safely insured.
Why might 412(e)(3) plans be attractive to older business owners who want to maximize retirement savings in a short period? Part of it is the way defined benefit plans differ from defined contribution plans. Business owners who participate in defined benefit plans can take a big share of the pie, particularly if they have few (or no) other highly compensated employees (HCEs). The company can also benefit from taking large income tax deductions for contributions made to a plan.
A fully insured defined benefit plan, such as a 412(e)(3), may be even more attractive than other defined benefit plans. Although the plan may sacrifice potentially higher investment returns, it offers some flexibility by using potentially lower-risk and easy-to-administer insurance and annuity contracts. These plans might also appeal to closely held business owners who want to maximize tax-deductible contributions to a retirement plan in the early years of ownership.
As with all defined benefit plans, employers must have the financial stability to support their plan indefinitely. So 412(e)(3) plans usually aren't appropriate for start-up companies.
Tax-favored treatment for a 412(e)(3) plan isn't automatic. Your plan must meet several requirements, as spelled out in the tax code.
First, the plan must be a defined benefit plan funded exclusively by the purchase of annuity contracts or a combination of annuity contracts and insurance. You have to purchase the contracts from an insurance company licensed by one of the 50 states or the District of Columbia to do business with the plan.
Also, the contracts must provide for level annual (or more frequent) premium payments starting on the date each individual begins participating in the plan. Premium payments need to end no later than the normal retirement age of a participant — or by the date the individual ceases participation in the plan, if earlier.
Other mandates include:
Important: The plan has to meet all of these requirements. Any single omission will result in disqualification and loss of tax benefits.
In addition, other special rules may come into play. For example, if life insurance contracts are used to partially fund a 412(e)(3) plan, the amount of any life insurance coverage available is limited to an amount considered to be "incidental" to the plan's purpose. This calculation is complicated and is best left to experts to determine.
One of the other advantages of a 412(e)(3) plan is that you can add this option even if your business also offers a 401(k) plan. But this isn't a do-it-yourself proposition. Get professional guidance to ensure you establish your new retirement plan according to the tax code.
Get in touch today and find out how we can help you meet your objectives.
