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A Plan That Can Help Clients Make Up For Lost Time

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Picture this: A self-employed engineering consultant, age 52, walks into your office one Monday morning and tells you he has done virtually no retirement planning since he got his start in the field 30 years ago. He intends nonetheless to work for another eight years, then chuck the business for more leisurely pursuits: golf, mountain climbing, globe-trotting, and quality time with the wife and grandkids.

Now, he wants your advice. You think to yourself, a lost case? Not to worry. A specialized defined benefit plan, the 412(i), will permit our late-to-retirement-planning consultant to save very substantial sums of money between now and age 60–far more than can be achieved using conventional defined contribution and profit-sharing plans.

“These plans are appropriate for clients older than age 45 who expect to work only over the short term, have substantial cash flow they don’t need to live on today and are highly motivated to prepare for retirement,” says Philip Harriman, first vice president of the Million Dollar Round Table and a partner at Lebel & Harriman, Falmouth, Maine.

Adds Jeffrey Cullen, an advanced marketing consultant for Hartford Financial, Hartford, Conn.: “There’s a narrow but robust market niche for 412(i) plans. We’re seeing great interest in the vehicle among business owners who expect to be profitable over the next five years.”

A fully insured qualified pension plan, the 412(i) is exempt from the complex IRC Section 412 funding rules that apply to all other defined benefit plans. Upshot: The plans are much cheaper and easier to administer than conventional pension plans and, therefore, are affordable for small business owners.

The 412(i) doesn’t, for example, require hiring a high-priced actuary to determine employee contribution amounts, as all actuarial expenses are borne by the life insurance manufacturer that sold the plan. The insurance company also typically services the plan through a third-party administrator or TPA.

Plan contributions are determined by a formula that factors in the employee’s age and income. Like other defined benefit plans, 412(i) contributions are also subject to Section 415 of the Employee Retirement Income Security Act of 1974, which currently caps the benefit at $210,000 of annual income.

By comparison, contributions (including salary deferrals, employer match and catch-up contributions) to three alternative retirement solutions for small business owners–the SIMPLE, SEP and individual 401(k) plans–top out at $12,500, $44,000 and $44,000, respectively, in 2006.

“Even if you stack these plans, you don’t get close to what the 412(i) can deliver,” says Matthew Weinheimer, a principal at Ames & Weinheimer, Austin, Texas.

The 412(i) offers another benefit for the self-employed: tax-deductible contributions exceeding 25% of compensation. That advantage, observers say, is often as appealing for clients as are the high contribution amounts. As a result, advisors typically see a surge in interest in the fourth quarter.

“Clients at that time see they need a sizeable deduction to avoid trouble with Uncle Sam,” says Cullen. “That’s the time when we really need to focus our sales and marketing efforts.”

To be sure, the 412(i) is not for the faint of heart. Small business owners who adopt the plan have to make the same hefty contributions for at least five years. The rule applies both to them and, because the plans are nondiscriminatory under ERISA law, those individuals in their employ. For that reason, sources say, the 412(i) is generally not appropriate for companies that are in volatile industries or are experiencing widely varying revenue streams.

Because of the five-year commitment and nondiscrimination rule, the plans generally lend themselves to businesses of 10 or fewer–many insist five or fewer–employees. The plans could be financially untenable for companies with a large number of employees. And, sources stress, the plans are primarily for the benefit of the business owner.

Also to consider: Because the IRS code stipulates that they provide a guaranteed retirement benefit, 412(i) plans must be funded using life insurance contracts and annuities with fixed guarantees. For the business owner who is accustomed to the sometimes higher yields of variable products, the low guaranteed returns on 412(i) plans–from 1% to 3% in some states–can be hard to accept.

Moreover, life insurance policies cannot fund more than 49% of the plans; the balance must be allotted to fixed annuities. The IRS mandated this requirement in 2004 to rein in a widely marketed practice: distributing cash values to policyholders at low tax cost using artificially inflated surrender charges. The cash would later “spring” to its real market value.

The new IRC mandates also have made 412(i) plans less lucrative for advisors. Mark Connell, a financial planner and senior vice president at Capital Advisory Group, Dallas, Texas, observes that commissions on life insurance policy sales are much higher than on annuities. Plans funded solely with life insurance (as was permissible pre-2004) thus generated more in earnings than those incorporating annuities.

But advisors stress that no other retirement plan can match the 412(i)’s ability to build a very substantial retirement fund over a short period on a tax-deductible basis. Even variable life insurance policies, which offer unlimited growth potential, do not permit a deduction on premiums paid.

Who is buying into the 412(i)? Sources say they’re seeing demand among business owners across a wide spectrum of industries. The plan is particularly popular among self-employed professionals: architects, attorneys, doctors, accountants and others.

One reason, they note, is that funds accumulated in the plans’ life insurance contracts are protected against confiscation by creditors following bankruptcy. That’s a not insignificant benefit for professionals in high-risk practices, like surgeons, who face the constant threat of malpractice lawsuits.

By contrast, stand-alone life insurance contracts enjoy creditor protection only on a state-by-state basis and in varying amounts. Connecticut, notes Cullen, only protects the first $4,000 of a policy’s cash surrender value.

Such amounts are but a tiny fraction of the sizeable funds being stashed away into 412(i) plans. Weinheimer cites one client, an oil and gas consultant, who earns $650,000 per year and is investing $135,000 into a 412(i) plan.

The client originally wanted to fund the plan at a higher amount, but Weinheimer counseled against. Connell, too, thinks it prudent to peg the contribution to an amount below what the client believes is feasible.

“When owners say, ‘we can put away $150,000 per year,’ we’ll typically aim for $80,000 to $90,000 just to make sure they’ll hit the target,” says Connell. “If they don’t, they’ll have to submit a lot of paperwork to the Department of Labor. You don’t want to be in this situation.”

To be sure, the difference between the amount that clients put into the plan and what they take out can be substantial. A common technique used to increase the ultimate retirement benefit beyond the Section 415 limit is to roll the lump sum value of the benefit into an individual retirement account. The lump sum, however, needs to comply with the Section 415 benefit accrual limit and the provisions of the Retirement Protection Act of 1994.

Raymond Benton, a financial planner at Lincoln Financial Advisors, Denver, Colo., said several of his clients, all siblings and partners in a law firm, did just that. Funding a 412(i) with income derived from a family ranch they inherited, the siblings later terminated the plan, rolling the benefit into an IRA. Result: Each one secured $800,000 in retirement savings.

“If you get too aggressive with the plan, the IRS is probably going to disqualify it,” says Benton. “But in this situation, it worked out very well.”

And when clients do well, their advisors look good. That’s all the more true, sources say, when the advisors are leveraging strategies in which they possess superior expertise.

Says Harriman: “If you understand how these 412(i) plans work and present them to the appropriate clients, you distinguish yourself among your competitors in a significant way. Most advisors are not well versed in this area.”


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