Many of the listed transactions that can get your clients into trouble with the IRS are exotic shelters that relatively few practitioners ever encounter. When was the last time you saw someone file a return as a Guamanian trust (Notice 2000-61)? On the other hand, a few listed transactions concern relatively common employee benefit plans the IRS has deemed tax-avoidance schemes or otherwise abusive. Perhaps some of the most likely to crop up, especially in small business returns, are arrangements purporting to allow deductibility of premiums paid for life insurance under a welfare benefit plan.
Some of these abusive employee benefit plans are represented as satisfying section 419 of the Code, which sets limits on purposes and balances of “qualified asset accounts” for such benefits, but purport to offer deductibility of contributions without any corresponding income.
ReplyDeleteShould Clients Buy Life Insurance in 412(i) DB Plans?
Answer the following question by choosing which investment you would purchase. Assume you invest $100,000 and let it grow for 20 years. At the end of 20 years, investment A and B will have the following balances:
Investment A: $200,000
Investment B: $300,000
Of course the answer is B. Why? Because both investments cost the same amount, and after 20 years, B was worth $100,000 more. The decision is a no brainer.
Read the rest of the article with the understanding that I am discussing what is appropriate when helping small to medium sized business owners who are looking for large deductions into a qualified plan for themselves.
Purchasing Life Insurance in a Qualified Plan
If you are an owner of a profitable medium to small business, the chances are significant that you have been solicited by insurance agents, CPAs/accountants/EAs, attorneys, or financial planners about using a 412(i) defined benefit plan funded 50% with life insurance.
What is a 412(i) DB Plan? It is a qualified retirement plan that, by law, has to be funded with life insurance or annuity contracts. With a 412(i) DB (or non-412(i) DB plan), the EMPLOYER is funding the retirement plan to provide a specific retirement benefit for the employees at a specific retirement age. The retirement benefit is based on assumed growth rates on the money invested in the plan. The lower the assumed rate of return on the investment when the plan is setup, the more the employer must contribute to be able to provide the guaranteed retirement income for employees. Therefore, most advisors will use a very low assumed rate of return on the investments 2-3% to “jack-up” the deduction. Also, the closer an employee is to retirement, the more money needs to be contributed to the plan.
How is a 412(i) plan different from a 401(k)/PSP? With a 401(k)/PSP, money from the employer and/or employee goes into the plan where it is allowed to grow to any level (no restriction on growth) and can be used for retirement purposes by vested employees. So if a 401(k)/PSP was funded for employee X and the account value of his/her money grew at 12% a year, the employees would vest and be able to use ALL of that money in retirement. With a 412(i) DB plan, if the returns on investments in the plan exceed the assumed rate of return, the future contributions of the employer would be lessened and the guaranteed retirement income would not change.
Why do clients use 412(i) plans? Because with the right demographics of a small business, 412(i) plans allow for the largest corporate deduction into a qualified plan for the owner.
Why does life insurance (LI) help create a larger deduction? The simple answer is because a LI policy is NOT a good investment (insurance loads) and by funding 50% of the annual contributions into a life insurance policy (vs. annuities), the assumed rates of return are driven down, and therefore, the required contributions are driven up.
For a FREE multi-page summary of how 412(i) plans work, please e-mail info@thewpi.org.
Let’s get back to the initial question. “Would you rather buy investment A or B”? The answer is B, and you don’t even have to think about it.
ReplyDeleteShould Clients Buy Life Insurance in 412(i) DB Plans?
Answer the following question by choosing which investment you would purchase. Assume you invest $100,000 and let it grow for 20 years. At the end of 20 years, investment A and B will have the following balances:
Investment A: $200,000
Investment B: $300,000
Of course the answer is B. Why? Because both investments cost the same amount, and after 20 years, B was worth $100,000 more. The decision is a no brainer.
Read the rest of the article with the understanding that I am discussing what is appropriate when helping small to medium sized business owners who are looking for large deductions into a qualified plan for themselves.
Purchasing Life Insurance in a Qualified Plan
If you are an owner of a profitable medium to small business, the chances are significant that you have been solicited by insurance agents, CPAs/accountants/EAs, attorneys, or financial planners about using a 412(i) defined benefit plan funded 50% with life insurance.
What is a 412(i) DB Plan? It is a qualified retirement plan that, by law, has to be funded with life insurance or annuity contracts. With a 412(i) DB (or non-412(i) DB plan), the EMPLOYER is funding the retirement plan to provide a specific retirement benefit for the employees at a specific retirement age. The retirement benefit is based on assumed growth rates on the money invested in the plan. The lower the assumed rate of return on the investment when the plan is setup, the more the employer must contribute to be able to provide the guaranteed retirement income for employees. Therefore, most advisors will use a very low assumed rate of return on the investments 2-3% to “jack-up” the deduction. Also, the closer an employee is to retirement, the more money needs to be contributed to the plan.
How is a 412(i) plan different from a 401(k)/PSP? With a 401(k)/PSP, money from the employer and/or employee goes into the pl