The first major potential problem relates to the funding of the plan itself. If life insurance is used in combination with an annuity as a funding vehicle for the 412(i) plan, advisors must follow the incidental benefit rules. The IRS considers any nonretirement benefit in a qualified plan to be incidental so long as that benefit is less than 25% of the total cost of the plan.
There are two practical tests developed by the IRS to consider whether a death benefit is “incidental”:
The participants insured death benefit must be no more than 100 times the expected monthly retirement benefit, or
The aggregate premiums paid (premiums over the life of the plan) for a participants insured death benefit are at all times less than the following percentages of the plan cost for that participant: whole life insurance, 50%; term insurance, 25%; universal life, 25%.
Any funding design that violates both of these tests should be scrutinized very carefully because any funding design that violates the incidental benefit rules threatens the qualification of the plan and threatens adverse tax consequences to the client.
The second major area for potential problems relates to the distribution or sale of the policy from the plan to the business owner or other participant. As mentioned above, the plan participant may, under certain circumstances, receive the policy as a distribution from the plan.
At least three major issues should be considered when discussing this: