Growing businesses always are looking for ways to attract and retain valuable employees. Providing a wide range of benefits from executive compensation and retirement to life insurance and health care is one of the ways employers can accomplish this. Companies are finding that 419(e) single-employer welfare benefit plans or 412(i) defined benefit plans can help fill the void in their employee benefit program.
419(e) Plan Basics
Single-employee welfare benefit plans can add to a company’s benefit program by providing a pre-retirement death benefit and/or a post-retirement medical reimbursement on a tax-advantaged basis. Employees receive a valuable employer-provided benefit while the employer receives a current tax deduction.
A 419(e) single-employer welfare benefit plan is not a qualified plan, so there are no premature withdrawal penalties, minimum distributions or maximum contribution or compensation limits. However, 419(e) plans are subject to the Employee Retirement Income Security Act (ERISA) of 1974 and are thus subject to all the appropriate regulations and requirements.
Family-owned entities may find these plans attractive because they can replace benefits that would otherwise be paid with after-tax dollars. Since family businesses often have relatively few non-family employees, the cost for benefits to non-family employees may be relatively small.
Because 419(e) plans provide employee benefits other than deferred compensation and retirement benefits, they must not be structured as a deferred compensation or retirement plan. Specific benefits covered by the plan can include disability, medical, supplemental unemployment severance and life insurance benefits.
Below is an overview of one application that may be of great interest to family-owned entities.
419(e) Post-Retirement Medical Reimbursement Plan
Business owners can address employees’ concerns over the rising cost of post-retirement health care costs by contributing to a 419(e) post-retirement medical reimbursement plan (PRMRP). Tax-deductible contributions allow employers to use pre-tax dollars to fund a reserve account for post-retirement and long-term health care benefits.
Reimbursements can be made for almost all out-of-pocket health expenses and even long term care insurance premiums. Reimbursements can be made to either plan participants, their spouses and, under income tax rules, their dependents.
The benefit must be offered to all full-time employees meeting a nondiscriminatory minimum age and service requirement. The benefit is popular with family businesses because the plan may be designed so that no one vests until they reach retirement and participation ends at termination of employment. This benefits remaining employees–usually the owner’s family.
Income Tax Treatment of Employees
Employer contributions to a 419(e) PRMRP are not taxable to the employee. After retirement, the distributions are not viewed as income as they cover health care and long term care expenses. Both plan contributions and distributions are tax-free.
Funding the Trust
Contributions to a 419(e) PRMRP must be placed in a trust that may own a life insurance policy. Because 419(e) is not a qualified plan, the trust may have to pay income tax on trust earnings. However, if cash value life insurance is purchased, amounts that would otherwise be taxed to the trust accumulate tax-deferred inside the policy.
IRC Section 419 limits deductions to the “qualified cost” for any taxable year. The qualified cost is reduced by the after-tax income of the fund, which also reduces the employer’s tax deduction. Tax-deferred vehicles such as life insurance do not decrease the tax deduction and are attractive funding mechanisms.
When life insurance is used as a funding vehicle, the 419(e) PRMRP trust must be the owner and beneficiary of the policy.
412(i) Plan Basics
Business owners considering a 412(i) plan generally need to enhance their retirement income. A 412(i) plan also can provide life insurance protection. The best candidates for 412(i) plans are small, closely held businesses, companies with few or no common-law employees, or companies with larger employee groups but wishing to create defined benefit “carve out” plans.
The 412(i) defined benefit plans allow for initially higher plan contributions in early plan years when compared to traditional defined benefit plans. And, a 412(i) plan is always fully funded, unlike traditional defined benefit plans, which can be over- or underfunded. 412(i) plans offer flexibility, which may help a client manage cash flow better than a traditional defined benefit plan and its required quarterly contributions.
Plans may be funded exclusively with a combination of life insurance and an annuity or just an annuity.
412(i) Distribution Options
In addition to providing an income stream at retirement, a 412(i) plan can offer other options such as a lump-sum equivalent rolled over into another qualified plan or Individual Retirement Account. An annuity contract could be distributed or surrendered, subject to any applicable company-imposed surrender charges.
However, if a life insurance policy is involved in the distribution, the distribution only can be rolled over into a profit-sharing plan but not into an IRA. If life insurance is no longer needed, the plan participant may receive a lump sum from the surrendered life insurance policy, after applicable company-imposed surrender charges.
If life insurance continues to be needed, the plan participant can receive the policy as a taxable plan distribution or purchase the policy from the plan. It should be noted that on Aug. 26, 2005, the IRS issued final regulations regarding the valuation of life insurance policies for income tax purposes. These regulations provide that the taxable value of a policy that is transferred out of a qualified plan such as a 412(i) plan is its fair market value.
Tax Advantages and Updates
Because 412(i) plans are based on product guarantees, they don’t have to adhere to the minimum funding requirements that apply to defined benefit plans. The former typically offer larger income-tax-deductible contributions in the early years, unlike most traditional defined-benefit plans.
A fully insured 412(i) plan is a defined benefit qualified retirement plan funded exclusively with insurance contracts. To qualify as fully insured for the plan year, a 412(i) plan must be funded solely with annuity contracts or a combination of whole life insurance policies and annuities, and must meet several other requirements.
Because of the insurance and annuity policy guarantees, a fully insured 412(i) plan is exempt from standard minimum funding requirements and no plan actuary is needed to certify the plan contributions.
Including a life insurance policy in the 412(i) plan can help protect the participant’s family. For income tax purposes, the plan participant must recognize the current cost of the life insurance death benefit protection as measured by IRS Table 2001 or the insurer’s lower published rates if those rates meet IRS requirements.
If the plan participant dies, the beneficiary will receive this portion of the death benefit income tax-free. The cash value is subject to income tax similar to any other distribution from the plan.
Pre-retirement or benefits planning, including the consideration of 419(e) or 412(i) plans, should be pursued with the advice of tax and legal counsel, as well a third-party administrator experienced in administering either of these plans.
M. Michael Babikian is the Director of Strategic Marketing Services for Transamerica Insurance & Investment Group. He can be reached at Michael.firstname.lastname@example.org.
Single-employee welfare benefit plans can add to a company’s benefit program by providing a pre-retirement death benefit and/or a post-retirement medical reimbursement on a tax-advantaged basis
Including a life insurance policy in the 412(i) plan can help protect the participant’s family