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.