The most contentious product in the DB world today is undoubtedly the 412i plan, named for the Internal Revenue Code section that offers special treatment for plans that are fully-funded by guaranteed insurance company products. The guarantees within the insurance vehicles eliminate the business owner's risk that the plan assets will earn less than the actuarially assumed rate, says Josh Jenkins of The Hartwood Group LLC, a 412i provider in San Diego. A 412i is also relieved of annual certification by an actuary, a requirement that other DBs must meet. That lowers the cost of running a 412i. But the client must pay for insurance, which can be expensive.
Although this variant has been around for decades, the super-sized contributions now available in light of the legislative changes have sparked new interest in it. One 412i Web site trumpets a contribution of nearly $500,000 for a 55-year-old owner with no employees. Yet the jumbo deductions and abuses such as insurance in excess of the amount permitted as an "incidental death benefit" have caught the eye of the IRS, and new regulations aimed at curbing abusive plans are widely expected soon. Policies with springing cash values are especially likely to be affected, insiders say. In the midst of uncertainty, some financial professionals are avoiding 412i's entirely.
There is also debate about the applicability of the confiscatory excise tax. Proponents of the plans say that a 412i will trigger the tax only when a client has a death benefit beyond incidental limits or if the plan is poorly designed. Detractors assert that the colossal contributions can quickly lead to overfunding. Best bet for the advisor: Before adopting a 412i for a client, make sure it won't be overfunded in the event that the plan is terminated. Ask whether the client will be able to access the plan assets without incurring the tax, and whether there are any other circumstances that could trip the levy. Again, you should develop a careful exit strategy at the time of plan inception to preclude potentially disastrous tax consequences later.
If you do go the 412i route, be sure to use a highly rated insurance carrier, Jenkins says. While many 412i providers target businesses with ten or fewer workers, some offer plans for companies with hundreds of employees.
Favored Plan Designs
Many older owners who have employees are now adopting tested cash-balance plans. These let the owner stash a lot for himself, and little for the workers. In one example presented at the NAPFA gathering, Temkin showed that a 53-year-old business owner was able to save $110,000 while making contributions of just $21,300 for a roster of four employees ranging in age from 25 to 55. With a traditional DB plan, on the other hand, the cost of staff contributions would probably be prohibitive.
Tested cash-balance plans are also attractive for organizations with multiple owners, such as medical groups or law firms. In contrast with a traditional DB, which does not maintain separate account balances for each participant (making it difficult to allocate the total plan pie among participants), a cash-balance plan does. "A cash-balance plan looks and feels a lot like a defined-contribution plan," says Van Iwaarden.
This is important at many law firms, for instance, because if a partner wants to contribute an additional amount to the retirement plan, her pay is reduced by the same amount. "The (paycheck) reduction is explicit, so the attorney will want to see that money coming back to her," Van Iwaarden says. "In a cash-balance plan, everybody has their own account, so there is a direct link between the money that goes into the plan for an individual and the amount that comes out to her." Cash-balance plans don't promise a lifetime income in retirement. Instead, a retiring participant's account balance, which grows at a rate stated in the plan, can usually be withdrawn in a lump sum or converted to a series of income payments.
A final approach to consider for clients is a DB-DC combo. Historically, IRC Section 415e prevented you from simultaneously maxing out benefits under both types of plans, but that rule was repealed not long before the 2001 tax act was enacted. Now clients can double dip. A common tactic involves adding a DB to an existing profit-sharing plan. In these cases, "the employer is really switching his thought process," says Sutten. "The DB is going to be the main retirement plan, and any discretionary contributions which are affordable beyond that in good years will fund the profit-sharing benefit."
Cash-balance and 412i DB plans can also be combined with a DC. For instance, The Hartwood Group is layering cross-tested 412i plans on top of existing profit-sharing plans with the goal of creating a combo in which 80% or more of the contributions are skewed to the owners. "At least 40% of all eligible employees, up to a maximum of 50 individuals, must participate in the 412i, while the remaining workers go into the profit-sharing plan," Jenkins explains.
Good candidates for this structure are large doctor groups with more than ten employees, he says. "The physician-owners end up in the 412i and are able to make contributions of $100,000 to $300,000-plus annually, while the employees in the profit-sharing plan receive a safe-harbor contribution that is a percentage of their salary."