412(i) Plan

What Is a 412(i) Plan?

A 412(i) plan is a type of defined benefit plan in which every benefit is funded through insurance contracts, usually individual life insurance policies, annuity contracts, or a combination of the two. The name comes from a section of the Internal Revenue Code. The Pension Protection Act of 2006 renumbered that rule as section 412(e)(3), but the older label remains in common use.

How It Works

In a defined benefit plan, the employer promises a specified retirement benefit, and an actuary calculates the contributions needed to fund that promise. A traditional plan usually invests those contributions in a portfolio of stocks and bonds. A 412(i) plan instead pays premiums into insurance contracts, and the insurer provides the guaranteed benefits.

To qualify, the plan must be "fully insured." The contracts generally must have level annual premiums and benefits guaranteed by the insurer. Because the funding is fixed and guaranteed, the plan's design and cost are closely tied to the insurance products chosen.

These plans are most often used by small businesses, especially those with a few owners who are older and have higher incomes. Contributions can be relatively large for older participants, and the balances can grow with tax deferral until benefits are paid out.

Why It Draws Scrutiny

The Internal Revenue Service has examined these arrangements closely. Concerns have focused on plans where premiums go largely toward life insurance coverage rather than retirement savings, and on plans where contributions appear excessive relative to the benefits provided. The IRS has identified some arrangements as abusive, and such plans can face penalties and loss of tax benefits. Because the rules are technical and depend heavily on plan design, tax treatment varies from case to case.

Advantages and Disadvantages

• Guaranteed benefits that do not depend on investment returns
• Potentially large tax-deferred contributions for some older owners
• Higher costs, including insurance commissions and administrative fees
• Less investment flexibility than typical retirement accounts
• Complex setup, annual administration, and reporting requirements
• Heightened IRS attention to aggressive designs