Vol 8 No 6		October 2006

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412(i) Plans Continue to be a Problem

Life insurance is always part of the 412(i) sale, usually taking 50% of the contributions because this is where the huge commissions are. Insurance sales firms aren't likely to get into 412(i) sales and be satisfied with 3% to 4% annuity commissions, when they can get 70% of the life insurance premium the first year.

412(i) plans are defined benefit pension plans that require plan contributions to be invested in annuities or life insurance. Our March 2003 Life Insurance Perspectives described abusive 412(i) plans that were invested exclusively in life insurance with springing cash values. High income taxpayers, mostly physicians, took grossly high deductions for contributions into their 412(i) plans and after five years were instructed to purchase the life insurance from the plan at ridiculously low value that then increased at compounding rates of 35% to 40% for the next five years. This tax avoidance scheme was never legitimate because the life insurance must be valued at its fair market value. Congress responded to this springing cash values slight-of-hand by enacting 402(a) that provides a specific formula for valuing life insurance sold or distributed by a pension plan. Our next Perspectives will comment in detail about life insurance valuation.

Unfortunately 412(i)s continue to be a problem for clients even though the springing cash values scam is no longer possible. The typical pitch is for clients to load up on large deductible contributions for three to seven years and then terminate the 412(i) and roll the assets into an IRA. Life insurance is always part of the sale, usually taking 50% of the contributions because this is where the huge commissions are. Insurance sales firms aren't likely to get into 412(i) sales and be satisfied with 3% to 4% annuity commissions, when they can get 70% of the life insurance premium the first year.

Darin, a consultant, was sold a 412(i) plan. Darin didn't need or want life insurance. The sales pitch implied that life insurance was needed for 50% of the contribution, which isn't true. Darin, 40, contributed $120,000 to his 412(i) with $60,000 paid as a life insurance premium with death benefits of $2,760,000. Darin intended to terminate his plan in three years as was recommended. Because Darin had no need for the life insurance he was going to surrender it before moving the 412(i) assets to an IRA. What Darin didn't realize is that the life insurance surrender value in three years will only be about $60,000 after having paid premiums of $180,000.

Even if Darin were to keep his plan to retirement, funding the 412(i) plan with unneeded life insurance is a huge drag that keeps his contributions higher than they otherwise would be. On a present value basis the loss in higher contributions is about $220,000.

There are two other potential problems. First, setting up a 412(i) plan with the intention of terminating it in three years could disqualify the plan. Treasure Regulation 1.401-1(b)(2) requires that a pension plan must be established as a permanent program. Termination for legitimate business purposes is allowed, but the Service could challenge a plan that is terminated in three years as originally intended.

The second problem is that the amount of life insurance is excessive. Life insurance is considered an incidental benefit in a pension plan. Generally, the amount of life insurance benefit that can be paid to a beneficiary is 100 times the expected monthly benefit. In this case Darin's scheduled monthly benefits are $10,000, but the life insurance benefits are 276 times this monthly benefit. The excess life insurance is considered an asset of the plan. If there are other participants it might be applied to fund their benefits. That said, it is quite likely that Darin's beneficiary would eventually receive the full death benefits, but not before some interesting twists and turns with other participants entering the fray with legal representation.

Even when life insurance is wanted and needed, buying it within a pension plan is about a four-and-a-half-of-one, half-dozen-of-another proposition. In other words, life insurance in a pension plan isn't an awful thing to do, but on balance is usually slightly negative. However, when life insurance isn't wanted or needed it obviously has no place in any pension plan.

Generally, 412(i) plans should stick to funding with annuities only.