Course Objective - The WPI · The SIMPL E 401(k) has been largely replaced by the safe harbor 401(k). Here’s a Comparison Chart for SEP vs. SIMPLE: Description SEP SIMPLE Specifically

Qualified Retirement Plan Course Material for the CWPP™ Certification Course ________________________________________________________________________

Copyright-The Wealth Preservation Institute (www.thewpi.org) 1

Course Objective This course was created to teach advisors (CPAs, EAs, accountants, attorneys, financial planners and insurance advisors) about Qualified Retirement Plans. Retirement planning is a topic that many advisors think they know well, but could use more information in order to give the best advice possible to high income clients. As a general statement, most medium to small businesses owners would like to defer as much money as possible while contributing the smallest amount for the employees. While many advisors simply tell their clients to “max out” a 401(k)/Profit Sharing Plan, there are several variations to 401(k)/Profit Sharing Plans that can dramatically favor the highly compensated owner/employees. In addition to 401(k)/Profit Sharing Plans, due to recent tax law changes, Defined Benefit Plans, in particular Cash Balance plan designs, as well as, 412(e)(3) Defined Benefit Plans (formerly referenced as 412(i) Plans) have once again become viable retirement vehicles for many business owners. This material will cover common and advanced “qualified” retirement plans available to clients and illustrate to advisors why one plan is better than another (depending on the type of client looking for benefits). The material will also discuss some of the problems with the plan in the marketplace and how to avoid the pitfalls when implementing non-prototype plans for clients.

Qualified Retirement Plans

Introduction U.S. households held $10.7 trillion in retirement assets at the end of 2010, according to a pair of retirement industry analysts who culled information from the Federal Reserve’s Flow of Funds report and U.S. Census data. In the year 2000, one of every eight Americans was over age 65 and this will increase to one of every five by the year 2025. These facts alone witness the tremendous and lucrative opportunities now and for years to come for advisors who choose to give advice to clients on retirement planning.

Many of these opportunities are with current clients. An important part of being an advisor is to offer ideas to your clients. They may not always be interested in those ideas, but a message is sent to them that you are aware and care about their particular situation. A question you may ask to your clients is, “Do you need to accumulate retirement savings and/or need tax deductions on your corporate or personal tax return?” Usually the answer is “YES”. A critical question at this point in time is what type of retirement plan does my client need?

http://www.thewpi.org/



A retirement plan is sponsored by a business (vs. an individual taxpayer). An unincorporated, self-employed individual (sole proprietor), partnership, LLC or a corporation is eligible to sponsor a qualified retirement plan even if there are no employees other than the owner(s).

For most privately held businesses, choosing the right retirement plan is

one of the most important financial decisions because the plan must suit not only the owner/employee’s immediate needs but also his or her financial, business and retirement profile. A major consideration is that in retirement years, income for retirees usually comes from three sources:

-Social security benefits.

-The regular savings or equity of the retiree, (home(s), investments) and

-Retirement plan savings, such as IRAs and employer-sponsored retirement plans

For most successful clients, Social Security benefits will not offer a significant

portion of that income at retirement. This leaves the other two items to provide the bulk of retirement income.

A qualified plan offers benefits to both employer and employees:

Employers -Employer may receive a tax-deduction for plan contributions -Employers are able to attract and retain high-quality employees. A

qualified plan may be the tiebreaker that wins over a skilled person who is offered relatively similar compensation packages from different potential employers.

-Business owners are able to reduce their income (and in turn their

income taxes) by sometimes as much as several hundred thousand dollars a year.

Assets in a qualified retirement plan are not subject to general creditors of either the employer or any employee participant under Federal law.

Employees

-Employees are provided with the opportunity for their retirement years to

be more financially secure when an employer funds a qualified retirement plan for their benefit.




-For plans that provide salary-deferral features, employees are able to defer paying taxes on a portion of their compensation until their retirement years, when their tax bracket is usually lower.

This material will review the more popular retirement plan options

available in today’s market. Those providing clients with the most tax savings will be explored in greater detail.

Individual Retirement Account (IRA) Plans For an employer, an IRA, SEP and SIMPLE plans are the easiest to understand and administer. However, these plans are also the most limiting on how much can be put into them in a tax deferred manner each year. In addition, these plans are the most rigid in the eligibility, contribution limits.

An Individual Retirement Account (IRA) is a personal savings

plan that allows clients to set aside funds for your retirement. Investments made within these plans grow in either a tax deferred or tax free environment. The following are the current and future contribution limits. For more information on the contribution limitations with an IRA please see the education module on IRAs.

Year IRA contribution limit

Catch-up

age 50+

2015 and after $5,500 $1,000

While almost anybody can make a contribution to a traditional IRA, only a few are allowed to actually deduct the amount contributed to the IRA.

If you are eligible to participate in a pension, your ability to deduct your IRA contributions is phased out based upon your income.

AGI Phase-Out Limits for Deductible Traditional IRA

Your Filing Status Is... And Your Modified

AGI Is... Then You Can Take...

single or head of household

$61,000 or less a full deduction up to the

amount of your contribution limit.

more than $61,000 but less than $71,000

a partial deduction.

$71,000 or more no deduction.


http://www.irs.gov/retirement/article/0,,id=202510,00.html




Your Filing Status Is... And Your Modified

AGI Is... Then You Can Take...

married filing jointly or qualifying widow(er)

$98,000 or less a full deduction up to the

amount of your contribution limit.

more than $98,000 but less than $118,000

a partial deduction.


married filing separately

less than $10,000 a partial deduction.


A Simplified Employee Pension (SEP) plan is a special type of

individual retirement account (IRA) that is extremely popular among owners of small businesses and sole proprietors. If your clients are the owners of the business or sole proprietor, they may contribute up to 25% of the salary their pay into a SEP. The maximum annual contribution, however, is limited to $53,000 for 2015. Remember that if a client establishes a SEP-IRA, he/she must also include all eligible employees. Eligible employees include anyone who earns more than $450 and has had any service in three of the past five years. For example, if an employee/owner contributes 10% of his/her salary to a SEP, he/she must also contribute 10% of each eligible worker’s salary to their own IRA.

The SIMPLE (IRA) (Savings Incentive Match Plan for Employees) is a “simplified” version of the famed 401(k) plan for employers with 100 or fewer employees. The major virtue of this plan is that nondiscrimination testing usually found with 401(k) plans is eliminated. A SIMPLE also has certain administrative aspects that have made it the plan of choice for many small employers. A SIMPLE plan allows employees to defer dollars from their own paycheck (up to 12,500 for 2015), and generally requires a dollar for dollar match up to 3% of pay or a 2% non-elective contribution from the employer. This 3% match or 2% contribution is the buyout of the testing requirements usually found in 401(k) plans.






The SIMPLE 401(k) has been largely replaced by the safe harbor 401(k). Here’s a Comparison Chart for SEP vs. SIMPLE:

Description

SEP SIMPLE

Specifically designed for self-employed people and small

business owners who typically employ less than 25 employees.

Designed for small businesses with 100 or fewer employees. The plan is funded by employer contributions and can also be funded by elective employee salary

deferral.

Employer Contributions

Required uniform percentage of each employee’s pay

Employer is required to make either an annual matching contribution or a non-

elective contribution of 2% of compensation.

Maximum Total Annual

Contributions

25% up to $53,000 2015 Maximum employee contribution of $12,500 and ER contribution of 2% -

3% of salary.

Maximum Deductions

25% of all participant’s compensation

Same as maximum contribution

Vesting Schedule for

Employer Contributions

All contributions 100% vested All contributions 100% vested

Withdrawals / Distributions

(Follows traditional IRA Regulations)

Permitted subject to tax and, if under 59 ½½, potential 10%

penalty.

Permitted, however, if under age 59 ½, potential 10% penalty. (25% penalty if

account is less than 2 years old.)

Deadline for Establishment

of Plan

Any time up to date of employer’s return (including extensions).

Any time between 1/1 and 10/1 of the calendar year. For a new employer coming in to existence after 10/1, as

soon as administratively feasible.

Deadline for Contribution

Due date of employer’s return (including extensions).

Employee contributions:

30 days following the end of the month with respect to which the contributions

are made.(12/31)

Employer contributions:

Due date of employer’s return (includes extensions)




ERISA Plans

Perhaps the single most profound piece of legislation regarding tax-qualified retirement plans was the Employee Retirement Income Security Act of 1974 (ERISA). This landmark legislation tamed the “wild-west” of old retirement plans by codifying requirements regarding:

1. Eligibility 2. Participation and Coverage 3. Minimum Vesting Standards 4. Nondiscrimination Rules 5. Fiduciary Responsibility 6. Minimum Funding Standards for “pensions” 7. Reporting requirements 8. Creation of the Pension Benefit Guarantee Corporation (PBGC)

Essentially, pension plans must operate by specific rules set forth in a

written plan document and participants must receive periodic information about their plan. ERISA resulted in IRC section 401(a) being added, hence many of these plans are often referred to as “401(a)” plans. You may recognize the noted subsection 401(k) which falls under this Code section.

When working with ERISA plans, you should be aware of these specific

issues and terms:

-The Plan Document (establishes and provides rules for the Trust) -Summary Plan Description (SPD) issued to all “interested parties” -Plan Sponsor (the business owners who adopt the Plan) -Plan Trustee (often the business owners, but may be another party) -Third Party Administrator (TPA) (a firm that specializes in providing pension services and reporting to assist the Trustees) -IRS form 5500 series (annual IRS reporting) The single most important thing for you to remember when working with

retirement plans is that every recommendation you make must be allowable within the Plan Document. Another important issue is that the Plan must exist PRIOR to the end of the plan or fiscal year (e.g. by 12/31). Back-dating plan documents is not allowable under the Code.




Related Employers

Perhaps the largest issue in making sure that a qualified plan satisfies nondiscrimination testing and remains compliant is the inclusion of all “related employers” as joint sponsors of the plan. That’s because many small business owners may indeed own or control more than one enterprise. It is tempting to adopt a 412(e)3 plan to benefit one group of employees, and not cover all the related employees, but this may not be possible under current pension law as a plan must meet specific coverage and participation rules. [IRC §410(b) and §401(a)(26)]

Generally, all the employees of businesses under common control are

aggregated for nondiscrimination testing vesting and top-heavy rules. Also the 415(a) contribution and 415(b) benefit limits will aggregate as if all the employees worked in one single employer. [IRC §414(b)]

Presented here are definitions of the “controlled” and “affiliated” service groups that the professional advisor must consider before recommending adoption of any qualified retirement plan.

Parent-Subsidiary Controlled Group

1. One business must own at least 80 percent of another business.

2. If the businesses in item 1 together own 80 percent of a third business, the third business is also a member of a parent-subsidiary group.

Brother-Sister Controlled Group 1. Five or fewer persons own in combination at least 80 percent of the

stock of each business, AND 2. The same persons own more than 50 percent of each business

counting only identical ownership in each business. 3. A person’s stock ownership is not taken into consideration for the 80

percent test in item 1 above unless the person owns some stock in each business. [IRC§1563(a)]

4. Attribution rules for stock ownership of spouses and certain family

members may apply. [IRC §1563(d)]




Brother-Sister Controlled Group (con’t)

Example:

Owner Business 1 Business 2

A 50% 40%

B 30% 60%

C 20% 0%

Result: Businesses 1 and 2 are members of a Brother-Sister Controlled

Group because A and B own at least 80 percent of both businesses and more than 50 percent of both, counting only up to 40 percent ownership for A and 30 percent ownership for B. Because C owns no stock in Business 2, C is disregarded for the 80 percent ownership test.

Combined Group 1. Consists of three or more businesses, each of which is a member of a

parent-subsidiary or a brother-sister group; and 2. One company is both a parent of a parent-subsidiary group and a

member of a brother-sister group.

Affiliated Service Group 1. Consists of a service organization (e.g., medical practice, law firm or

other service business) and an affiliated organization (e.g., employs nurses or paralegals) which is at least 10 percent owned by highly compensated employees of the organization, AND

2. The affiliated organization performs services for the service

organization, which account for at least 5 percent of the gross receipts of the affiliated organization. [IRC §414(m)]

Example: Dr. Smith owns 100 percent of Medical Practice. She also owns

20 percent of Nurses, Inc., a firm whose employees provide nursing services to Medical Practice. 50 percent of Nurses, Inc.’s gross receipts are on account of services provided to Medical Practice.

Result: Medical Practice and Nurses, Inc. are members of an Affiliated

Service Group.




PBGC Plans Only defined benefit pension plans that are qualified under Internal Revenue Code (Code) Section 401(a) are covered by the PBGC's plan termination insurance program. Certain defined benefit pension plans are exempted from coverage, however, if they are classified as any one of the following types of plans:

1. A governmental plan, including plans under the Railroad Retirement Act;

2. A church plan that elects not to be covered;

3. A non-U.S. plan for nonresident aliens;

4. An unfunded deferred compensation plan for a select group of management or highly compensated employees;

5. A plan that since the enactment of ERISA has not provided for employer contributions;

6. A plan that benefits only substantial owners, where a substantial owner is a sole proprietor or partner who owns 10 percent or more of the capital or profit interest in a business entity, or in the case of a corporation, a person who owns 10 percent or more of the voting stock or total stock of the corporation;

7. A plan of an international organization that is tax exempt under the International Organizations Immunities Act;

8. A defined benefit plan to the extent that it is operated as an individual account plan; or

9. A plan established and maintained by a professional service employer that did not have, at any time since the enactment of ERISA, more than 25 active participants

What is an individual account plan? A plan that provides benefits based solely on the amount available in an individual's account is an individual account plan. Therefore, a target benefit plan is an individual account plan and would not be covered by the PBGC. A cash balance plan, however, does not provide benefits directly through an individual account and is covered by the PBGC.




PBGC Plans (con’t) What is a professional service employer for purposes of PBGC coverage requirements?

A professional service employer is a sole proprietorship, partnership, or corporation that is owned or controlled by professional individuals. A professional service individual includes, but is not limited to, physicians, dentists, chiropractors, osteopaths, optometrists, other licensed practitioners of the healing arts, attorneys at law, public accountants, engineers, architects, draftsmen, actuaries, psychologists, scientists, and performing artists. [ERISA §4021(c)(2)] In addition, the PBGC generally defined a professional individual in PBGC Opinion Letter 76-106 [Sept. 3, 1976] as follows:

In our view, a professional individual generally is one who provides services which require knowledge of an advanced type in a field of science or learning customarily acquired by a prolonged course of specialized intellectual instruction and study, as distinguished from a general academic education and from an apprenticeship or from training in the performance of routine mental, manual or physical processes. The rendering of professional services generally requires the consistent exercise of discretion and judgment in its performance and would be predominantly intellectual in character. ________________________________________________________________

Profit Sharing Plans A profit sharing plan is often the plan of choice for many small-business

owners and professional practices because the contributions can be made with complete discretion. These tax-deductible contributions may be reduced or suspended in any given year that the employer chooses. Actually, “profit sharing plans” is a bit of a misnomer. We prefer to think of these plans as entirely discretionary retirement plans. Employers can fund them in an unprofitable year, or decide not to contribute in even the most profitable year. Non-profit organizations may also adopt them. That’s flexibility.

Recent favorable tax laws have made these plans better than ever.

Advisors who do not sell qualified plans for a living can team up with a qualified advisor who can show clients how to harness these new rules and take their planning to what the client will perceive as the “Next Level.”




Profit Sharing Contributions Each year, the sponsoring employer may decide to allocate from 0 – 25%

of the “eligible payroll” into the plan. Eligible payroll is the total of the allowable wages of the participants who are eligible to receive a contribution that year. It should be noted that, allowable wages for any individual participant above $265,000 (indexed limit for 2015) are ignored for profit sharing calculations.

The following point is often confused under the tax law: any one participant may contribute a 401k elective up to 100% of pay, not to exceed $18,000 plus a catch-up limit of $6,000 for participants that are age 50 or older (indexed elective 401k and catch-up limits for 2015). Additionally, a profit sharing contribution can be made. The total 401k elective plus profit sharing contribution cannot exceed the annual addition limit of $53,000 (indexed annual addition limit for 2015). The catch-up contribution requires a 401k plan provision, however it is not a calculable part of the annual addition limit and it is disregarded for all plan testing purposes.

It should also be noted that the total employer contribution still can not

exceed 25% of the eligible payroll unless combined with a cash balance or traditional pension plan under the rules as outlined in the Pension Protection Act of 2006 (PPA 2006).

Non-PBGC profit sharing plans when combined with a defined benefit

pension plan in any form limit the employer contribution to a sum not to exceed 6% of the eligible payroll. This apparent “disadvantage” is more than offset by upto a 100% defined benefit contribution, as well as, an optional 401(h) add-on post-retirement medical benefit account provided by the pension. 401(h) maximum contributions are 33.33% of the total pension retirement contribution.

Three “Next Level” Tools to Consider

A retirement plan can not discriminate in favor of “highly compensated

employees” in either contributions or benefits. This, however, does not mean that everybody has to receive the same contribution. Far from it; when designing a “Next Level” profit sharing plan, many pension plan providers offer three tools that can be used to craft the plan that best meets your client’s goals and budget. These Include:

1. “Integration” with Social Security

2. Age-Weighting the Contribution

3. New Comparability Classification Plans

This Example dramatically illustrates the value of “Next Level” Tools:




Current Age- New-

Employee Name Age Salary Traditional Integrated Weighted Comparability

Owner (key) 55 $265,000 $53,000 $53,000 $53,000 $53,000

% of Pay 20% 20% 20% 20%

Key Employee 45 $100,000 $20,000 $16,484 $15,701 $5,000

% of Pay 20% 16.85% 15.70% 5%

Employee 1 30 $40,000 $8,000 $6,740 $1,847 $2,000

% of Pay 20% 16.85% 4.62% 5%

Employee 2 35 $35,000 $7,000 $5,897 $2,431 $1,750

% of Pay 20% 16.85% 6.95% 5%

Employee 3 30 $25,000 $5,000 $4,212 $768 $1,250

% of Pay 20% 16.85% 3.10% 5%

Total $93,000 $76,300 $73,747 $63,000 % to Owner 57% 55% 72% 84%

Integrated Profit Sharing Plans

All employers already sponsor at least one retirement plan, jointly funded

by employers and employees. It’s called the Old Age & Survivor Benefit of Social Security. Government rules let you take this into account by allowing you to “integrate” your qualified retirement plan with your Social Security contributions. Although the rules are flexible and somewhat complex, this concept helps employers skew additional benefits to the highly compensated employees while lowering them somewhat for the lower-paid workers.

Under an Integrated Profit Sharing Plan, compensation is broken out into

two parts; the amount above the integration level (excess compensation), and the amount below the integration level (base compensation). Usually the integration level is the Social Security Taxable Wage Base in effect for the applicable year. The employer is permitted to “offset” their contribution to Social Security by applying a lower contribution percentage to the base compensation (i.e.: the base percentage) and a higher contribution percentage to the excess compensation (i.e.: the excess percentage).

A Profit Sharing Plan Integrated with Social Security works best in

situations when the company wants to make greater contributions to highly compensated employees who are the same age or younger than the other employees.




Age-Weighting The final regulations governing nondiscrimination (found in IRC 401(a)(4))

introduced an old pension plan concept to profit sharing plans. Recall that the contribution can not discriminate in either contributions or benefits. Therefore, giving everybody 20% of pay is clearly nondiscriminatory. However, giving each the same theoretical retirement benefit is also nondiscriminatory (as with a defined benefit plan).

Why is Age-Weighting a profit sharing plan helpful? The reasoning is

simple: with fewer years until retirement, older participants require larger contributions than younger participants to get to the same benefit level.

A review of the design chart shows that this plan is perhaps the most

favorable to the owner. However, in operation, it is a little cumbersome. Older employees get higher contributions, period. Employees in the same job, getting similar wages, will get very different contributions unless they share the same age. Because of these reasons, this plan is less popular than the next option.

New Comparability

Perhaps the most exciting development in pension plans, this “Next Level” design offers a method to allocate significantly greater contributions to specific classes of employees. It combines both the integration and age-weighted rules, but uses weighted averages to determine the contribution. This plan is ideal for principals who:

-Are older and earn more than most of their employees;

-Want the biggest possible share of the plan contribution allocated to their own accounts; and, -Desire the contribution flexibility of a profit sharing plan. This type of plan is known by many names: “super-integrated,”

classification plan, group allocated plan and more commonly “new comparability.” Because it was finalized in the Code in 1993, it is really no longer new, so we prefer to call it super comparability since it is among the most flexible of plans and can target, with precision, extra benefits to select classes of employees.

New Comparability is highly customizable and can be matched to your

client’s business quite easily. For example, groups can be created for different profit centers, subsidiaries, sister companies or, most commonly, by job class—in short, any clearly identifiable group. Some common examples include:




1. Owners 1. Sr. Partners 1. Executives 2. Non-Owners 2. Jr. Partners 2. Managers 3. All Other Employees 3. Employees of Subsidiary A 4. Employees of Subsidiary B

Some sponsors get quite creative to create clearly identifiable classes that best match their business organization. Interestingly, creating different classes does not mean you have to give different contributions in any given year. In some years, you can give each class zero or perhaps 25% of pay to everyone. It’s your call, as long as the contribution satisfies testing each year.

The basic rule of thumb is that the contribution you give to the bottom

group(s) will determine how much you can give to the others. If the preferred groups are, on average, older than the bottom groups, you should be able to leverage modest contributions to the rank and file employees into substantial contributions to the other groups.

Nondiscrimination Testing

Because “New” Comparability can be perceived as potentially abusive, the

IRS updated the rules effective January 1, 2002, to provide firm guidance on how to establish a plan. These rules help us to advise you on how to tailor your groups and allocate the contribution. There are two basic issues that you should be familiar with:

1. The 3:1 Rule 2. The 5% Rule

Generally, the allocation to the top group can not exceed three times the allocation to the bottom group and must satisfy the testing. Therefore, if you give 3% of pay to each employee in the bottom group, then the top group can not receive more than 9% of pay, assuming that 9% passes testing. Once you award 5% of pay to the bottom group, then the 3:1 ratio disappears. With the proper circumstances, plans with allocations of 25:5 can be created when the top group was 15 years older than the average employee.

401(k) Plans The 2001 Tax Law has, perhaps for the first time, made the 401(k) Plan among the best retirement plan designs for even the smallest of employers. That’s because the new law fundamentally altered the way these plans operate regarding treatment of the employer contributions vs. the employee contributions. When combined with sophisticated tools and concepts found in other sections of the tax code, you get the unparalleled advantages of “Next Level” 401(k) Plans.




The Economic Growth and Tax Relief Reconciliation Act of 2001 greatly expanded and simplified the 401(k) world. Each employer may now contribute up to 25% of the “eligible payroll” in the form of profit sharing, matching contributions or combinations of each. The prior limit was only 15% of the payroll and was reduced by the salary deferrals, which is no longer the case.

Salary Deferrals 401(k) Employee Voluntary Elective Contributions The new law dramatically increased the amount that any employee can potentially defer into a profit sharing plan with a 401k voluntary elective deferral provision. It also allows any participant who is age 50 or older during the plan year to contribute additional “Catch-Up” deferrals. These limits are typically adjusted annual. 2011 401k elective deferral limits are as follows:

Deferral Catch-up Total Age 50+

2015 $18,000 $6,000 $24,000

These individual, elective deferrals, upto 100% of pay with a maximum of

$18,000 (indexed limit for 2015, can now be added to profit sharing contributions and matching contributions with the total of all contributions not to exceed $53,000 plus the catch-up if over age 50 of $6,000 or a total of $59,000 (indexed limit for 2013

The Problem Many small-business owners would like a plan that is fairly inexpensive to fund yet provides significant benefits for the owners, family members or highly skilled workforce. Unfortunately, in a 401(k), the amount that “highly compensated” employees may save is dictated by the savings rate of the “non-highly compensated” employees.

Although the rules are complex, salary deferrals of the highly compensated employees versus the others, as a percent of salary, may be summarized as follows:




Average Deferral Percentage (ADP)

Non-Highly Compensated Highly Compensated

0% 0%

1% 2%

2% 4%

3%* 5%

4% 6%

6% 8%

8% 10%

*For the first year of a new plan, the rate of deferrals for the non-highly

compensated employees can be assumed to be 3% of pay, so the highly compensated employees may defer 5% as a group.

Key Issues for Consideration Who is “Highly Compensated?”

A highly compensated employee is defined by government regulations to be:

1. A greater than 5% owner and any linear family member (e.g., son, daughter, mother, father) of such owner. 2. Anyone who received more than $120,000 (indexed amount for 2015) of compensation in the prior year, and (at the option of the plan sponsor) was in the top 20% of all employees. Most small-business owners employ spouses and other family members. Even though they may earn far less than $120,000, they still are considered “highly compensated.”

“Top Heavy” Concern

Another problem that often arises in a small-business 401(k) is that once 60% or more of the plan assets attribute to the owners, their family (as described above), or certain officers, the plan becomes “top heavy.” Although having 60% or more of the plan assets is often desired by the owners, it may necessitate that the employer contribute at least 3% of salary to all the eligible employees, or the smallest percentage contributed for a Key Employee, if less.




Thus, a plan that was supposed to encourage employee savings with a minimal cost for the sponsor may be more expensive than anticipated. Fortunately, the new law counts any matches against this minimum, reducing the problem somewhat.

“Safe Harbor” 401(k)

Congress has recognized the pitfalls of traditional 401(k) plans and has offered two alternatives for you to consider. These “Safe Harbor” provisions can steer the plan sponsor clear of the troubled waters they may have once faced. These provisions remove the Average Deferral Percentage (ADP) test and, with the new tax law, also satisfy the “Top Heavy” concern. However, the prime consideration is that any safe harbor contribution made using either method must be immediately vested and is owed to all employees even if they leave the plan during the plan year.

1. Safe Harbor “Match”

The employer agrees to match employee contributions, with immediate vesting as follows:

-100% up to 3% of pay

-50% on the next 2% of pay

Thus, an employee who defers 5% or more of pay will get total matches of at least 4% of pay. Of course, if employees defer less, they get less, or nothing if they are eligible and elect not to defer anything.

2. Safe Harbor “Non-Elective”

Another very easy way to add a fail-safe provision to the plan is simply to award 3% of pay, with immediate vesting, to each eligible participant. Thus, all employees receive some benefit in the plan, regardless of whether or not they elect to defer anything.

How to Use These 401(k) Safe Harbors As easy as these provisions are to understand, they become a bit trickier to implement. That’s because the IRS is concerned that unscrupulous plan sponsors would choose to use these provisions at the end of the plan year, and the employees may not be able to take full advantage of them in a short period of time. Here are the guidelines for using them:

1. A brand new 401(k) can use either design as long as the plan is installed before the fourth quarter of the plan year (e.g., prior to 10/01 for calendar year plans).




2. An existing plan must provide notice at least 30 days prior to the beginning of the plan year (e.g., by 12/01 of the preceding year for calendar year plans) stating either that they MAY or they WILL use the provision the following year. 3. Assuming the “we may” notice was given in the prior year, the employer must decide 30 days before the beginning of the plan year (e.g., by 12/01 for calendar year plan) whether or not he or she will be using the safe harbor to satisfy discrimination testing. If the employer chooses to use the safe harbor, then the plan must be amended to include the safe harbor provisions.

As these rules are somewhat cumbersome, it is recommended that the plan document specify whether or not this will be a safe harbor design in the next or first plan year. If you do not specialize in 401(k) planning, it is wise to affiliate with a reputable pension plan administrator who has a staff dedicated to helping advisors with these difficult issues.

Planning Note 1: The 401k account can be given different eligibility ‘terms” than the profit sharing account. For example a plan can be written requiring Age 21, 1 year of service and full time status to participate in the 401k. The Profit Sharing part of the plan can have immediate eligibility for all. Why? This arrangement allows your employer to include part timers for testing purposes i.e. they are participants in the profit sharing plan but not the 401k. If a safe harbor is used it vests 100% immediately. So the part timer, not eligible for the 401k will be used for testing in PS, will not vest due to part time status unless they become full time or reach retirement age. Planning Note 2: Safe harbors can be conditional or unconditional. Conditional allows for an owner “look back” between 90 to 30 days before the plan year end to post a Notice of whether or not the Safe harbor will be used in the current plan year. The issue may be vesting, 100% immediate with a safe harbor or graded upto 6 years otherwise or the employer/plan sponsor may simply not have the funds do to economic conditions. An unconditional safe harbor must be funded no matter what the economic circumstances are. The plan sponsor may want to make some additional plan change. The unconditional safe harbor could prevent him from doing so. The conditional safe harbor = planning flexibility.

“DASH 401(k)”

Perhaps the most exciting development in retirement plan design today is the “New Comparability” Profit Sharing Plan.

This innovative method allows the sponsor to make substantial

contributions to selected groups of employees while limiting the cost for other groups by using an “age-weighted” mechanism to satisfy nondiscrimination testing. Essentially, if the preferred employees are older than the average age of




the non-preferred employees, this design can dramatically skew benefits to the older groups.

A Double Advantage Safe Harbor (DASH) 401(k) plan combines a “safe

harbor” 401(k) plan with a new comparability profit sharing feature. The results are often dramatic, and compelling.

Current Salary 3% Safe New Total

Employee Name Age Salary Deferral Harbor Comparability Contribution

Owner (key) 55 $265,000 $18,000 7,950 27,050 $53,000

% of Pay 6.8% 3.0% 10.21% 20%

Key Employee 45 $100,000 14,000 3,000 5,000 22,000

% of Pay 14% 3.0% 5.0% 22%

Employee 1 30 $40,000 ? 1,200 564 1,764

% of Pay 3.0% 1.41% 4.41%

Employee 2 35 $35,000 ? 1,050 494 1,544

% of Pay 3.0% 1.41% 4.41%

Employee 3 30 $25,000 ? 750 353 1,103

% of Pay 3.0% 1.41% 4.41%

Total 13,950 33,461 79,411

% to Key 78.5% 95.8% 94.5%

In the case above, you will note that there are two “key” employees, the

owner and an officer of the company. The owner wants to favor himself first and the key employee second. Another goal is to keep the employee benefit cost reasonable or minimal, if possible.

A DASH 401(k) accomplishes these objectives by first awarding a flat 3%

“safe harbor” to all eligible employees. This is the ONLY required employer contribution each year. By awarding this safe harbor, both the owner and the Key employee may defer the maximum with ADP testing. By including a new comparability profit sharing feature, the owner can dramatically skew added benefits to himself and his Key employee with discretion. Thus, the safe harbor and the new comparability provision combine to offer a Double Advantage.




The “Micro(k)SM

” Another plan that should be considered in lieu of a SIMPLE or SEP-IRA is

what we call the “Micro(k).” These are known by various other names to include: “Uni-K,” “One-Life 401(k),” “Solo 401(k)”, etc., and have strong appeal following the passage of EGTRRA ’01.

A 401(k) salary employee deferral can now be added on-top of the employer profit sharing contribution until the participant reaches the 100% of pay not to exceed $53,000 indexed defined contribution limit (for 2015).

Those participants who turn age 50 or older during the current year may also make “catch-up” contributions even if they exceed the $53,000 limit. Thus, a 50-year-old may have up to $59,000 between the employer contribution and salary deferral in 2015, as long as he/she is deferring the maximum allowed under the law or the plan.

Importantly, when there are no common-law employees (e.g. Micro(k) plans only work when the only eligible employees include the owners and their spouses), there is no need to worry about nondiscrimination testing and ,there are relaxed reporting rules. This translates into lower administrative and set-up costs. The “Micro(k)” is a moniker we use to denote “very small” 401(k) plans. It is a marketing concept, rather than a statutory plan design.

Let’s compare a Micro(k) to a SEP-IRA for the following participant, age 50:

SEP-IRA Micro-K

W2 Salary $100,000 $100,000

Owner Contribution $25,000 $25,000

Salary Deferral - $18,000

Catch-Up - $6,000

TOTAL $25,000 $49,000

Unlike a SEP or SIMPLE, life insurance can be a permitted investment in the “Micro(k)” which presents interesting sales opportunities for those who have life insurance needs. A properly crafted, cash-value life insurance contract may have a long-term yield that is comparable to a bond-fund and thus may be an excellent diversifier.

A Micro(k) can also include a loan provision where the owner employees may borrow up to ½ the account balance from the Plan, up to $50,000. These loans are paid back into the plan (with interest) ratably over five years. This added liquidity can be very important to a small business owner who has a bad year and needs cash. As he essentially borrows money from himself, all the interest goes back into his account. By contrast, a SEP or SIMPLE-IRA can not offer this important feature.




Money Purchase Plans Unlike profit sharing and 401(k) plans, a Money Purchase Plan is a true

“pension” plan and is therefore subject to minimum funding standards. Under a money purchase pension plan, a fixed percentage of compensation is contributed to the plan each year, regardless of profits. The contribution is paid by the company and is deductible by the company. The maximum allowable contribution to a single participant cannot exceed 25% of annual compensation or the annual addition limit in effect for that year ($53,000 in 2015). The disadvantage of the money purchase plan is that once the company decides on the percentage contribution, it becomes fixed for subsequent years unless amended. Even if the revenues from the business are down, the employer is still obligated to make the contribution in the required amount. Failure to meet the contribution, or during requirements will result in an excise tax on the deficiency.

The Economic Growth and Tax Relief Reconciliation Act of 2001

(EGTRRA) dealt the Money Purchase Pension Plan a severe blow. The annual deductibility limit for the Profit Sharing Plan has been increased from 15% to 25% of compensation, therefore making it equivalent to the contribution limit on a Money Purchase Plan. When plan employers consider the inflexibility of the Money Purchase Pension Plan’s contribution and distribution requirements relative to the Profit Sharing Plan, few will elect to use a Money Purchase Plan.

It is interesting to note that many clients still have money purchase plans

due to the lack of good service on the part of their pension advisors. If your clients have a money purchase plan, you should counsel them to

re-visit whether it makes sense for them to switch to the much more flexible profit sharing plan or perhaps a DASH 401(k).

Once employees have “accrued” or earned a benefit, which will generally

happen when an employee participant has attained 1000 hours of service in a plan year, that benefit cannot be taken away. Accordingly plan changes should be made prior to accruals being earned. A plan change subsequent to accruals being earned must recognize the accruals already earned.

All pensions are subject to earned accrual rules.

Defined Benefit Plans Following some very favorable tax legislation in the late 1990s, defined benefit plans have once again emerged as one of the best ways for a successful small-business owner to save substantial sums for retirement. Unlike defined contribution plans (e.g., 401(k) and profit sharing), defined benefit plans are not limited to a $53,000 individual contribution limit, nor is the business owner limited




to no more than 25% of the “eligible payroll.” A properly crafted defined benefit plan can take retirement savings to the “Next Level” by creating much greater tax deductible contributions and retirement benefits.

The Problem Many small-business owners and professionals put off saving for retirement to invest money in their business or practice, pay for their children’s education and enjoy their working years. Now, with stable and growing income (profits), they look to catch up in a fairly short period of time. Unfortunately, it takes both money and time to build retirement savings. Even if the money is available, most retirement plans severely limit the amount that can be deducted and placed within the plan. Retirement dollars not placed within the Plan are eroded by federal, state and local income taxes and by payroll taxes that can easily add up to 50% of income.

The Solution Consider the following: a 52-year-old small business owner who earns $210,000 or more in salary and plans to retire at age 62 can select from the following plans, with an assumed 5.5% investment yield:

Annual Accumulation

Accumulation At age 62*

Profit Sharing $53,000 $682,394

Defined Benefit $202,618 $2,608,780

How is This Possible?

As read in the previous material defined contribution plans provide a tax-deductible contribution that is limited to a fixed dollar amount (e.g., $53,000). The monies are placed within a retirement trust and grow tax deferred until received at retirement as ordinary income. The retirement benefits depend solely on the investment yield achieved for the dollars invested. Thus, the retirement benefit is unknown, but the contribution is predictable. A defined benefit plan works in reverse. The benefit is known (as selected by the employer), and the necessary contribution is calculated to achieve that benefit at “normal retirement age.” Because this calculation is complex and is subject to stringent government guidelines, an enrolled actuary must review the plan each year and certify that it is operating properly. The basic concept, however, is fairly simple: the fewer the years until retirement, the larger the required contribution.




Who Should Consider This Plan? A defined benefit pension plan will reward the high-income, mature participants (the Baby Boomers, for example, will benefit far more than Generation X). In fact, age is more important than salary when calculating the anticipated level cost for the benefit. Although there are many ways to design a plan, let’s return to our example of a person earning $170,000 who wants the maximum benefit at age 62 using an assumed 5.5% investment yield for various ages: W-2 Comp Required ages 35 to 40 = $70,000; 45 = $80,000; 50 = $100,000; 55 = $130,000.

Age DB Plan Contribution Accumulation 35 $68,200 $2,600,000 40 $87,300 $2,600,000 45 $123,700 $2,600,000 50 $145,400 $2,600,000

Today a 30 year old making $70,000 can put $53,000 into a pension + up to $53,000 into a combined 401k + PS + 401(h); total $106,000. The 30 year old could also use an offset plan year and add an additional $140,000 for a total 1st year contribution of $246,000. Second and subsequent years would be in excess of $140,000.

How Do These Plans Work? Unlike a defined contribution plan, a defined benefit plan (other than a 412(e)3 “Fully Insured” plan) does not have participant accounts. Rather, the sponsor gives the required contribution to the plan trustee who then invests all of the trust assets into the plan. Benefits are then paid from the plan as employees become eligible and are vested. Generally, the benefit is expressed in terms of monthly income at normal retirement age (e.g., $17,500 each month, or $210,000 per year for a maximum plan from our example). However, most small-business plans will offer a lump-sum conversion for any vested benefit. In our prior example, this benefit is converted to $2.6 million, which may then be rolled to an IRA or successor defined contribution plan.

Side note: It should be noted that some advisors setup over funded defined benefits plans using low assumed rates of return and then advise their clients to terminate the plans after five year of funding. The money would be rolled over to an IRA which does not have growth limits on the return on investments. This is not a good idea for advisors looking to keep their clients and themselves out of trouble with the Department of Labor.




Should a participant opt for monthly income for life, this liability is often shifted to an insurance company. This protects the trustee from having to ensure that sufficient assets exist until all retired participants die. The lump-sum conversion amount is a good approximation of what the insurance company may require to guarantee the benefit.

Participants married for one year or more must be offered a Qualified Joint and Survivor Annuity. This means that the monthly benefit is paid for the life of the retired participant. Should the spouse survive the participant, then at least 50% of the monthly check must continue to the spouse until his or her death. However, should the spouse consent, a single life annuity or lump sum may be paid from the plan. Often, life insurance is used to provide for the spouse who makes this election.

Defined Benefit Plan Design The maximum benefit allowable in 2015 is 100% of pay, not to exceed $210,000 per year at age 62 if (and only if) the participant has ten years of participation in the plan. However, not all plans should be designed for age 62 retirement. A “Normal Retirement Age” (NRA) can be selected between age 62-65 for participants with at least five years of participation. Thus, a 65-year-old new participant could have an assumed retirement age of 70. This (NRA) does not mean the person must retire at this age, it is simply used as an assumption to determine the theoretical benefit and required annual contribution. The basic principle is that the benefit is reduced for early retirement before NRA, and increased for delayed retirement beyond NRA. Also, recall that a reduction is made for less than 10 years of participation. So that you can better see the design flexibility of these plans, let’s look at the effect of selecting Normal Retirement Ages. We’ll assume our participant earns $170,000 with a 5.5% investment assumption. Defined Benefit Plan Design (con’t)

Age NRA Contribution Monthly Benefit

Lump Sum at NRA

50 62 125,852 14,167 2,062,154

55 65 149,297 14,167 1,922,252

60 65 172,199 7,083 961,058

65 70 235,674 11,075 1,315,321

70 75 254,094 14,167 1,418,118




Making a Commitment Unlike a profit sharing plan, a defined benefit plan must be funded each year. This means that even in a “bad year,” the pension plan contribution must be made since the benefit is promised by the employer. It is possible to make changes to the plan benefit formula on a prospective basis, but for benefits that are already accrued, the employer must deliver. For the plan to qualify as a bona fide retirement plan, the employer should be prepared to make a minimum five-year commitment. If this commitment can not be made, then an employer should consider staying with a profit sharing plan, where contributions are generally not required. To make sure that any non-owner employee is guaranteed to receive a benefit, the federal government requires most defined benefit plans to pay insurance premiums to the Pension Benefit Guaranty Corporation (PBGC).

Survivor Benefits A defined benefit plan has great flexibility in designing both the retirement benefit and the pre-retirement survivor benefit. A plan can specify the survivor benefit to be as low as zero, but it is often at least the “present value of the accrued benefit.” This is calculated by the plan actuary if a participant dies, and is similar to the benefit for somebody leaving the plan with a vested lump sum benefit. However, a significant pre-retirement survivor benefit can be added at the option of the employer. Since this benefit may be in addition to the retirement benefit, it should be insured by life insurance contracts or it could exhaust (or potentially exceed) the available trust assets. Interestingly, this added benefit may have a very low impact on the plan’s current cost (see Envelope Funding vs. Split Funding). Let’s return to our 50-year-old, earning $170,000 and with NRA 62.

Annual Accumulation Added Survivor

Contribution at age 62 Benefit

Plan A $125,852 $2,062,152 $0

Plan B $128,864 $2,062,152 $1,000,000

Many planners believe that using life insurance as a funding vehicle for guaranteed plans is a very efficient method of providing this coverage.




Envelope Funding vs. Split Funding

Plans using life insurance to provide a pre-retirement death benefit must consider the policy cash values as a part of the plan’s funding.

The Split Funding Method is often used with Whole Life insurance policies

where the guaranteed cash value of the policy at retirement is known. The Envelope Funding Method must be used with Interest Sensitive policies (such as Universal Life), where the cash value at retirement is not guaranteed or known. The Envelope Funding Method may also be used for Whole Life policies. When the Envelope Funding Method is used for Whole Life policies, plan contributions in the 2nd and future years may increase each year. The Plan Sponsor should be aware of which funding method is being used when a plan is partially funded using life insurance. The following chart illustrates the difference between Envelope & Split Funding for a 50 year-old participant who has a $165,000 salary history with a Normal Retirement Age (NRA) of 62.

Envelope-Funding Split-Funding

Life Insurance Face Amount $1,375,000 $1,375,000

Life Insurance Premium $33,176 $33,176

Year 1 Side Fund Contribution $92,894 $103,215



Year 12 Side Fund Contribution

$126,037 $103,215

Cash Surrender Value @ NRA

$310,228 $310,228

Side Fund Value @ NRA $1,691,228 $1,691,228

Total Assets @ NRA $2,001,456 $2,001,456

Side Note: This chart varies our prior examples somewhat by using a

lower assumed salary as the chart numbers were readily available. The teaching point is that there is substantial flexibility in how the Plan actuary chooses to fund the life insurance. This example also assumes a whole life policy, yet a UL contract may produce an altogether different “envelope” funding pattern in Year 2 when the actual cash values are known.

“Carve-Out” Defined Benefit Plans “Carve-out” retirement plans are fairly new to the pension industry. If you asked 10 small employers what their ultimate pension plan would look like, the employers would say they would like to put away as much money as possible for the owner/employees and as little away for the rank and file employees.




Several good things have come about in the pension industry with some of the recent law changes. New comparability (also known as super comparability) plans have come to be recognized as a viable way to help skew pension plan contributions in favor of the key employees. The rules changed to make defined benefit plans and 412(e)3 defined benefit plans a viable tool again (see the upcoming material for detailed information on 412(e)3 plans).

Carve out planning seems to be the next generation of planning to help small business owners create plans to skew the contribution amounts to key employees. Explaining the technical details behind why Carve-Outs work is outside the scope of this material, but the following example for a hypothetical Dr. McIntire will illustrate to the readers how powerful Carve-Out planning can be. The CWPP™ course is all about giving advisors more knowledge than other advisors and knowledge that will benefit the high income/net worth client. Knowledge on Carve Out planning can help advisors accomplish these goals.

“Next Level” Retirement Plan for David C. McIntire, DMD Step 1: Determine Your Goals and Budget Meet David McIntire, a successful dental surgeon with a small but thriving practice. He had been using a SEP-IRA plan to meet his retirement needs because he was told it was the cheapest and best option. As many “baby boomers” nearing retirement are now learning, a SEP-IRA may fall far short of actual retirement income needs. Dr. McIntire’s goals are to receive the maximum retirement benefit allowed by law and to retire by age 62. However, he wants to make sure his employee benefit costs do not get out of control. He can commit up to $200,000 a year to his tax-deductible plan and is pleased to know that assets within his retirement plan are protected from the claims of creditors and potential litigants. Step 2: Analyze Potential “Safe Harbor” Solutions An initial study reveals that Dr. McIntire may certainly improve his retirement security by turning to a defined benefit plan. That’s because the tax-deductible contributions are not limited to $53,000 as with his current SEP-IRA. Interestingly, the cost of Dr. McIntire’s traditional defined benefit plan is more than triple his SEP-IRA contribution, while the attributable cost for his Generation X employees is actually lower. Although he and his wife, Rita, receive the majority of the benefits, he is troubled by the benefit cost attributed to his baby boomer employee: Linda Booker.




Current Current

Plan Traditional

Defined

Employee Name Age Salary SEP-IRA Benefit Plan

McIntire, DMD(K) 50 $210,000 $42,000 $125,852

McIntire, R (K) 50 $40,000 $8,000 $27,634

Booker, L 55 $45,000 $9,000 $33,538

Clerk, A 30 $35,000 $7,000 $6,582

Clerk, B 25 $25,000 $5,000 $3,738

Nurse, N (Part Time) 45 $10,000 $0 $0

$71,000 $197,344

% to Key (K) 70% 78%

Projected Benefit for McIntire DMD (K) @62 $4,728 $14,167

Projected Accumulation for DMD (K) @62 688,195 $2,062,154

“Carve-Out” Planning Although employees who do not have one year of service or who are younger than age 21 can be excluded, all other eligible employees need to be considered for non-discrimination testing. There are two tests that must be satisfied annually. The first is fairly simple: at least 40 percent of the otherwise eligible employees need to be covered in the defined benefit plan. The second rule is more complex: the ratio of rank-and-file employees benefiting in each plan must be at least 70 percent of the ratio of the owners, their family members and other high-income employees. Note that we now included Nurse Nancy, his part-time surgical assistant, to satisfy this test in the profit-sharing plan. Thus, when there is more than one owner or family member in the business, a plan sponsor may choose to create non-discriminatory classes of employees to include or “carve-out” of the defined benefit plan. What about the excluded employees? Because the “carve-out” group will often contain family members and other highly paid employees who are important to the business, it is recommended that they be included in a separate plan. It is important to make sure that absolutely no employee participates in both plans, since this may cause some employer contributions to be non-deductible.




Current Profit- ““Carve-Out”” Total

Employee Name Age Salary Sharing Defined Benefit

Plan Plans

McIntire, DMD(K) 50 $210,000 $0 $125,852 $125,852

McIntire, R (K) 50 $40,000 $10,000 $0 $10,000

Booker, L 55 $45,000 $11,250 $0 $11,250

Clerk, A 30 $35,000 $6,582 $6,582

Clerk, B 25 $25,000 $3,738 $3,738

Nurse, N (Part Time) 45 $10,000 $2,500 $0 $2,500

$23,750 $136,172 $ 159,922

% to Key (K) 85%

Projected Benefit for McIntire DMD (K) @62 $14,167

Projected Accumulation for DMD (K) @62 $2,062,154

Step 3: Consider Advanced Design Services as Necessary Dr. McIntire likes the defined benefit plan idea but is concerned with the added expense and potential confusion of operating two plans for two different groups of employees. He would like to pursue a “Next Level” alternative that can accomplish a similar objective using one plan, if possible. After consulting with a CWPP™, who is supported by a quality pension plan administrator, to see if he is a good candidate, Dr. McIntire retains the plan administrator to prepare a “Next Level” defined benefit plan alternative. By using a “New Comparability” approach that places the employees and spouse in one class and the doctor in another, he can tailor the plan to meet his objectives. Like the “Carve-Out” plan option, this design works best when there are other family members or highly compensated employees that can be included in the more modest benefit group.

Current Current

Plan Traditional

““New Comparability””

Employee Name Age Salary SEP-IRA Defined Benefit

Plan Defined Benefit

Plan

McIntire, DMD(K) 50 $210,000 $42,000 $125,852 $125,852

McIntire, R (K) 50 $40,000 $8,000 $27,634 $8,275

Booker, L 55 $45,000 $9,000 $33,538 $10,042

Clerk, A 30 $35,000 $7,000 $6,582 $3,942

Clerk, B 25 $25,000 $5,000 $3,738 $2,238

Nurse, N (Part Time)

45 $10,000 $0 $0 $0

$71,000 $197,344 $ 150,349

% to Key (K) 70% 78% 89%

Projected Benefit for McIntire DMD (K) @62 $14,167 $14,167

Projected Accumulation for DMD (K) @62 2,062,154 2,062,154




A “New Comparability Plan” allows clients to craft a plan specifically to meet their retirement goals and business needs. By creating non-discriminatory classes of employees and placing them in various groups, clients can accomplish their objectives, while still providing meaningful benefits to everyone eligible. Dr. McIntire’s plan formula could look like this:

1. Dentists Who are Owners: 6.71 percent of final average salary times years of future service (maximum 24). 2. All Other Employees: 2.00 percent of final average salary times years of future service (maximum 24). The minimum monthly accrued benefit for any employee earning less than $37,500 in a year will be $111.00 for that year.

Complex testing must be made each year to ensure that your plan is nondiscriminatory. For this reason, the client must supply employee census and other plan data to the actuarial firm immediately after the end of each plan year. This will allow more time to calculate and discuss alternatives if your plan does not pass testing due to a change in employee census. The added administrative time and expense of this oversight and testing should be outweighed by the reduced employee benefit cost if this “Next Level” option is appropriate for you.

Combine a Cash Balance and a Profit Sharing 401k Plan to form a Super 401(k) Plan™

Many owners and partners are looking for larger tax deductions and accelerated retirement savings. Cash Balance plans may be the perfect solution for them. The PPA 2006 legislation is encouraging more and more professionals and successful business owners to adopt this type of plan.

A Cash Balance Benefit Plan (CBP) is a type of defined benefit retirement plan that "qualifies" for tax deferral and creditor protection under ERISA.

In a Cash Balance plan each participant has an account that resembles those in a 401(k) or profit sharing plan. To many a CBP participant account reminds them of a pass book savings account.

Participant accounts grow annually in two ways:

The company contribution – a percentage of pay or a flat dollar amount – is determined by a formula specified in the plan document, and;

An annual interest credit. The rate of return is guaranteed and is independent of the plan's investment performance. That rate changes each year but usually is equal to the yield on 30-year Treasury bonds, which has hovered around 5 percent in recent years.




The CBP often has considerably more design flexibility than a traditional or 412(e)(3) DB plan. However, either a traditional or a 412(e)(3) DB plan can also be combined with a profit sharing 401(k) plan. The combined plan design contribution depending on age will increase overall deductible contributions to 2X to 5X the otherwise DC annual addition limit. The following case study and example illustrate the dynamic planning capabilities of a Super 401k Plan™. CASE STUDY – A RADIOLOGIST GROUP PRACTICE--The Pension Protection Act of 2006 allowed this medical group to redesign their existing retirement plans to allow for materially larger contributions. The doctors are now enjoying contributions totaling $6,006,250 with a cost for all other participants of only $187,500. The percent to Doctors is a “whopping” 97.00%.

Comparatively a conventional stand alone profit sharing 401k plan would limit the doctors to a contribution of $1,644,000 collectively and increased the cost of other participants from a minimum of $125,000 (5%) to $187,500. The maximum employee contribution is an increase of $62,500 (subject to vesting and tax deductible) to attain an increase of $4,426,750 for the doctors.

Illustration of Retirement Plan Options for 2015

Age Compensation

(IRS limit) 401(k) Plan

Profit Sharing

Plan

Cash Balance Plan

Total Max Contribution

9 Doctors (60)

$265,000 $24,000 $35,000 $0 to $242,000 $301,000

12 Doctors (40-49)

$245,000 $18,000 $35,000 $0 to$150,000 $203,000

5 Doctors (30-39)

$230,000 $18,000 $35,000 $0 to $89,750 $142,750

4 Doctors (30-60)

$220,000 $18,000 $35,000 $0 $53,000

Subtotal $7,355,000 $6,070,750

53 Employees 7.5% of pay $0 each

$2,500,000 their

discretion $187,500 $0 $187,500

Total $9,765,000 $6,258,250

Percent to Doctors 97.00%

An example is the best way to illustrate the power of a Super 401(k)

Plan™.




What you will notice about the following numbers is that when you use just

a 401(k)/profit sharing plan, the percentage of deferred money going into the plan

for the owners is 88%. This may not be enticing to most owners.

However, when you use a combination of all three plans (401(k), PSP,

CBP), the percentage contribution to the business owners is 97.00%. That’s a

stunning number and the business owners will like.

Let’s look at another very interesting Super 401(k) Plan™ example.

Date Annual Profit Cash D/B

Name Age

of

Hire

415

Comp 401k Sharing Match Total

Balance

add on Traditional

3

Shareholders

JLP 55 1/01.93 230,000 20,500 13,800 9,200 43,500 100,000 182,897

RK 46 6/5/00 230,000 15,500 13,800 9,200 38,500 100,000 109,603

MK* 46 6/5/00 115,000 15,500 6,900 4,600 27,000 50,000 66,500

Subtotals 575,000 51,500 34,500 23,000 109,000 250,000 359,000

8 Non-

Shareholders

Profit

Sharing Rate for

Non-Shareholders is

7.5%. Total

GA 21 8/22/05 25,000 0 1,875 0 1,875 0 4,373

RO 40 2/14/05 27,000 0 2,025 0 2,025 0 8,460

GR 33 12/6/04 28,000 0 2,100 0 2,100 0 8,225

KL 27 1/12/07 33,000 0 2,475 0 2,475 0 6,715

ME 34 8/1/01 34,500 0 2,588 0 2,588 0 10,517

TI 29 4/14/05 34,500 0 2,588 0 2,588 0 7,589

WI 39 7/2/01 54,000 0 4,050 0 4,050 0 14,670

KL (Key) 67 1/1/01 125,000 20,500 9,375 5,000 34,875 0 34,875

Subtotals 361,000 20,500 27,076 5,000 52,576 0 95,424

Grand

Totals 936,000 72,000 61,576 28,000 161,576 250,000 454,424

Percent to Shareholders 65.6% 71.5% 56.0% 82.1% 67.5% 100% 79.0%

What should jump out at you is the percentage of contributions for the owners in the add-on CBP. The plan allowed for $250,000 worth of contributions for the owners and didn’t even require a contribution for the eight staff members. So the question for your clients who have a 401(k)/profit sharing plan is: would you entertain a plan where you could put away significantly more money for the owners if the contributions for the staff equated 0%? The answer for most clients looking to max-defer into a qualified plan is absolutely and now you know the power of a CBP when used in a Super 401(k) Plan setting.




Contribution Chart

Age 401(k) only 401(k) with Profit Sharing Cash Balance Total

30 $18,000 $53,000 $51,946 $104,946

32 $18,000 $53,000 $57,342 $110,342

34 $18,000 $53,000 $63,303 $116,303

36 $18,000 $53,000 $69,889 $122,889

38 $18,000 $53,000 $77,166 $130,166

40 $18,000 $53,000 $85,206 $138,206

42 $18,000 $53,000 $94,092 $147,092

44 $18,000 $53,000 $103,912 $156,912

46 $18,000 $53,000 $114,765 $167,765

48 $18,000 $53,000 $126,761 $179,761

50 $24,000 $59,000 $140,021 $199,021

52 $24,000 $59,000 $154,679 $213,679

54 $24,000 $59,000 $170,881 $229,881

56 $24,000 $59,000 $188,792 $247,792

58 $24,000 $59,000 $208,590 $267,590

60 $24,000 $59,000 $230,475 $289,475

62 $24,000 $59,000 $254,667 $313,667

64 $24,000 $59,000 $243,556 $302,556

66 $24,000 $59,000 $249,732 $308,732

68 $24,000 $59,000 $273,830 $332,830

70 $24,000 $59,000 $258,398 $317,398

72 $24,000 $59,000 $242,256 $301,256

74 $24,000 $59,000 $225,578 $284,578

76 $24,000 $59,000 $208,509 $267,509

78 $24,000 $59,000 $191,244 $250,244

80 $24,000 $59,000 $174,099 $233,099

412(e)(3) Defined Benefit Plans

Introduction

A 412(e)(3) plan (formerly referenced as a 412(i) plan) is a defined benefit pension plan, the funding requirements of which fall under Internal Revenue Code (IRC) §412(e)(3). If a plan meets the requirements of this subsection, it is exempt from the complex funding rules of §412 of the Internal Revenue Code applicable to all other defined benefit plans.

Following the passage of the Tax Reform Act of 1986 and the Omnibus Budget Reconciliation Act of 1987, defined benefit plans had lost much of their




luster for the small-business owner. Complex funding rules and market fluctuations resulted in over-funding, under-funding and increased premiums for the Pension and Benefit Guarantee Corporation (PBGC).

However, defined benefit plans, in general, and 412(e)(3) plans in particular, have benefited from recent, highly favorable tax legislation. SBPJA ’96 (Small Business and Job Protection Act of 1996) repealed family aggregation rules and also repealed IRC §415(e), which penalized former participants of “defined contribution plans” from the same employer. EGTRRA ’01 (Economic Growth and Tax Reconciliation Relief Act of 2001) greatly expanded the appeal of these plans as the benefit and compensation limits have substantially increased. The genesis of all pension plans is the fully insured concept. They are the oldest known forms of pension/retirement benefit plans. “Fully insured” 412(e)(3) plans (previously 412(i) plans) have been around since ERISA ’74 and may be an attractive option for very small, successful businesses and professionals. They offer:

-No market risk -Maximum current contributions -Guaranteed retirement benefits -Simplicity

For participants age 40 and older, both 412(e)(3) and defined benefit

plans offer unparalleled contributions and related benefits (as far as ERISA governed plans are concerned). Unlike defined contribution plans that may be limited to $53,000 (in 2015), the deductible contributions to these plans can be significant. It should be noted again that either a traditional or 412(e)(3) fully insured plan can be combined to create a Super 401k Plan™. With the right set of circumstances the retirement plan design can be incredibly effective. A Super 401k Plan™ Design using a fully insured 412(e)(3) pension can create annual tax deductible contributions for a 60 year old in excess of $300,000/year.

Overview of 412(e)(3) Requirements

In order for a plan to qualify under IRC §412(e)(3), certain requirements must be met. This subsection creates an exception for insurance contract plans from the complex funding requirements found in §412, and a different set of conditions must be satisfied:




The plan must be funded solely by individual or group life insurance and annuity contracts.

These contracts must provide guaranteed level premiums for all benefits including benefit increases. Payments begin when the participant enters the plan and extend until the retirement date under the plan.

All plan benefits must be provided by these contracts and be guaranteed by an insurance company to the extent that premiums have been paid.

The contracts must not lapse due to lack of payment for the current or prior years.

No rights under the contract may be subject to security interest.

Participants should not take loans. Any Automatic Premium Loans (APL) must be repaid before the plan year-end.

Forfeited benefits must reduce contributions. Forfeited benefits occur

when employees leave before becoming fully vested in the plan. The unvested portion of the terminated employee’s benefit must stay in the plan, which means that a lower contribution will be required to fund the remaining employees’ benefits.

Advantages

A “fully insured” plan can provide substantial retirement benefits under a simple and secure program. The accrued benefit for participants is simply the “cash surrender value” of all insurance contracts as defined under IRC §411(b)(1)(F). A 412(e)(3) plan may provide a maximum current tax-deductible contribution for the business. Some of its other advantages include:

-No market risk; all benefits are fully guaranteed by the insurance company. -No full funding limitation under ERISA §404(a)(1)(A). -There can be no over-funding, and therefore, no 50% excise tax (under IRC §4980) on any reversion of excess assets to the sponsor, as long as the maximum lump sum equivalent is not exceeded. (Which is not the case with a traditional defined benefit plan).




-There can be no under-funding, as the contributions are based solely on the guaranteed provision of the level premium contracts. -There should be no balance sheet liabilities under FASB 87; stated under the Financial Accounting Standards No. 87 issued in December 1986 (paragraphs 57-62). -No actuarial certification (and expense) required under ERISA §404(b)(2) (no need for an enrolled actuary). -No variable component PBGC premiums are due. Only the fixed $19 per participant (or less) needs to be paid to insure the benefits for the employees as required by ERISA Title 4.

Disadvantages

The 412(e)(3) plan is not the ideal plan for all situations and businesses. Given large, required contributions that must be made each year, it works only when the business is established and highly profitable. It works best when there are very few employees (less than five), where the owner is age 40 or above and is several years older than any of the firm’s employees. In brief, disadvantages of a 412(e)(3) plan include:

-Large, “required” contributions for employees (making the plan less flexible than traditional DB plans or Profit Sharing Plans). -No policy loans, including an Automatic Premium Loan (APL), can be outstanding at year-end. -No flexibility in investments. The plan must be funded exclusively through

insurance. -As a non-PBGC plan a 412(e)(3) plan when combined with a profit sharing 401k plan limits the profit sharing contribution to 6% of eligible payroll.

Client Profile 412(e)(3) plans do not work well for everyone. They are ideally suited for a mature small-business owner who is successful, may have delayed saving for retirement, avoids investment risk and can make a multi-year commitment. As the initial cost of the guaranteed benefit can be quite high, suitable clients typically have no more than three employees for every highly compensated participant or owner.




It does not matter what business form your client operates under. A retirement plan can work equally well for sole proprietors, partnerships, S or C Corporations and Limited Liability Companies (LLC). However, care must be taken to ensure that coverage and participation requirements are met for controlled and affiliated service groups as discussed earlier. Ideal Sponsor Profile:

-Age 40 and above;

-Fewer than five employees;

-Employees are younger than the owner;

-Stable, predictable income;

-Desires more than $50,000 contribution;

-Risk averse (to market losses); or

-Seeks added safe money diversification

Don’t overlook a classic defined benefit plan for sponsors that may be willing to trade the guarantees of a 412(e)(3) plan for greater investment flexibility or lower employee benefit costs. It is best to do a side-by-side comparisons to best evaluate the most suitable plan design.

Plan Design

How They Work A 412(e)(3) is simply an allocated defined benefit plan. Both plans define a definitely determinable benefit and then use a mathematical model to determine current costs. The amount that is necessary to satisfy the current funding requirement is deductible. [401(a)(1)(A)] The benefit that we can fund for will be specified in the Plan Document. Rather than a dollar amount, the document will most often express the benefit in terms of a formula that satisfies the benefit accrual rules of IRC §411(b)(1). A common formula may be 10 percent of pay times years of future service. The benefits are further limited to 100 percent of pay not to exceed $205,000 (indexed) at age 62 for plan years beginning in 2008 2013 [IRC §415(b)]. In addition to the basic “415 limit,” there are adjustments for fewer than 10 years of participation in the plan and for early (before age 62) or late (after age 65) retirement.




A classic defined benefit plan uses an unallocated trust to hold all plan assets and is managed by the Trustee. The plan actuary develops (and occasionally revises) the mathematic model comparing actual investments experience to the model. If the experience is more favorable than planned, the future contribution will decrease, if less favorable, future costs increase. By contrast, a 412(e)(3) defined benefit plan substitutes the guaranteed values and annuity purchase rates of the annuity and insurance contracts for the model. As these guarantees are often more conservative than allowable models for classic defined benefit plans, the initial contributions may be much greater. Should the insurance company pay excess interest or dividends, future cost will decrease. Thus, a 412(e)(3) plan arrangement will differ from life insurance company to company and may differ within a company if different products are used. In general, the lower the guaranteed rates, the higher the initial contributions. Some planners therefore posit that “the worse the insurance product is, the better the 412(e)(3) plan!” This logic has some initial merit, regarding initial plan contributions. However, in our experience, a client is looking for two things from a Plan:

1. Large Deductible Contributions 2. Something Valuable in Return for the Above

Whereas a 412(e)(3) plan that was guaranteed to lose all the client’s

money would have an unlimited deduction, it would make little economic sense. Thus, we look to work with established companies that provide a good product with an economically attractive guaranteed return. Although it is easy to find companies that guarantee as low a 1.5% on their products, the case studies in this book will use a more attractive 3.0% guaranteed rate that is still available from many fine companies who operate in this market.

412(e)(3) Funding Example So that you can best understand the funding differences, let’s compare a classic defined benefit plan to an “annuity-only” 412(e)(3) plan. The classic defined benefit plan assumptions are actuarially determined using a 5.5 percent pre-retirement and a 5.5 percent post-retirement interest rate with a mortality assumption using the 1994 GAR Male/Female Unisex Mortality Table. The 412(e)(3) guaranteed assumptions are based on a 3.0 percent pre-retirement and 3.5 percent post-retirement rate.




Participant Age 55 with $165,000 Salary, Normal Retirement Age (NRA) 65.

Classic 412(e)(3)

Defined Benefit

Plan “Annuity Only” Plan

First Year Contribution $144,902 $187,997

Monthly Benefit @ NRA 65 $13,750 $13,750

Accumulation @ NRA 65 $1,865,672 $2,155,172

A review of our case study reveals that each defined benefit plan option is providing the same benefit at age 65: $13,750 per month. The classic defined benefit plan is using a conversion rate of 5.5%. The 412(e)(3) design uses the annuity purchase rate specified in the contract. Note that the dollars necessary to provide the promised benefit are greater in the 412(e)(3) plan, as the guaranteed annuity purchase rate in our contract is lower than 5.5 percent. Also, as the annuity funding assumes the 3.0% guaranteed accumulation rate, the initial plan contribution is higher.

The following is an example of a comparison between 412(e)(3) annuity

only funding and funding a plan using the maximum amount of life insurance as an example (using the 100 times rule and RR-74-307). The ultimate retirement benefit will not change however, the current deduction is much higher and the client purchases a sizable death benefit for estate planning purposes.

Guaranteed 100 Time Additional RR-74-307 Additional

Age NRA Accumulation Rule Survivor Rule Survivor

at NRA Contribution Benefit Contribution Benefit

55 65 $2,155,172 $204,265 $1,375,000 $232,321 $3,750,000

Investments and Gains

Contributions for regular defined benefit plans fluctuate with actuarial and investment experience. To ensure minimum funding standards are met, an enrolled actuary is required by ERISA 404(b)(2) to certify the plan each year. Investment returns are not known and can vary greatly over time. It is this type of variability that can cause a traditional plan to become over-funded (a higher investment return or greater contributions than expected) or under-funded (lower investment return or lower contributions than expected).

A 412(e)(3) defined benefit plan works differently. Contributions are based on the worst case scenario (the insurance company pays only the guaranteed minimums). Thus, the initial cost is quite high but may decrease over time if the company credits higher returns to the annuity or pays dividends on any whole life insurance contracts used to fund survivor benefits. A 412(e)(3) plan can therefore




“front-load” the plan costs to its early years. When the returns from the investments eventually exceed their guaranteed rates of returns, contributions to the plans will need to be curtailed.

An added benefit is that a “fully insured” plan needs no actuarial certification, as only enough money to provide the known benefits can accumulate in the plan. There can be no over-funding or under-funding problems as long as the proper premium is calculated each year and actually paid by the plan sponsor.

Benefits

Top-Heavy Benefit

Like any other qualified retirement plan, a 412(e)(3) plan must satisfy the “top-heavy” requirements of ERISA §416. A plan is considered “top-heavy” if more than 60 percent of its accrued benefits inure to the benefit of Key Employees (generally greater than 5 percent owners of a business and other highly compensated individuals.) In today’s 412(e)(3) market, plans will most likely be “top-heavy.” Hence, a “fully insured” plan must normally provide a minimum benefit of 2 percent of compensation per year of service up to 10 years, and at least 20 percent for more than 10 years of service.

Since this minimum benefit accrues rapidly, level premium contracts (with low early cash surrender values) may not have sufficient cash to guarantee the payment of accrued benefits in the early years.

In some cases, an additional lump-sum contribution may be required to ensure that the non-key employees have a sufficient accrued benefit if they terminate service and are vested.

Retirement Benefits

A few code provisions have a bearing on the benefits paid at retirement. The first is a favorable ruling concerning the definitely determinable benefit under IRC §401(a). Rev. Rul. 78-56 allows a “fully insured” plan benefit to be increased if the actual annuity rate is more favorable at retirement, without violating the “definitely determinable benefit” rules.

The ERISA section that limits the overall plan benefit is known as the “415 limit.” IRC §415 applies to all defined benefit plans in the same way. It dictates the maximum retirement benefit that can be funded for. In 2011,this provision limits a defined benefit plan to a maximum of $195,000 of annual benefit. [IRC 415(b)(1)]




This amount is reduced if the actual retirement age is less than age 62 and is increased if retirement age exceeds age 65. [IRC 415(b)(2)(C)-(D)]

OBRA ’87 further modified the maximum 415 benefit by requiring at least ten years of participation in the plan to receive the full benefit. This adjustment is made fractionally. For example, a participant with only six years of participation (6/10) may receive only 60 percent of the maximum benefit. [IRC 415(b)(5)(A)]

Case Study

So that you can better understand the interplay between IRC §415 and the Plan design, let’s return to our case study of the 55-year-old participant looking to optimize his retirement contributions and benefits. A plan can be designed with various Normal Retirement Ages (NRA) that will determine the maximum monthly benefit. Recalc based on max $17,083.33 at NRD 65 and 62.

Current Age

NRA Maximum Monthly

Benefit

55 60 $5,967

55 62 $9,625

55 65 $13,750

Note that the benefit with a plan designed at NRA 60 would be reduced by

both the 10-year fractional rule and is adjusted for NRA earlier than 62. The maximum benefit at NRA 62 would be reduced only by the 10-year rule (70 percent of $17,083) and the benefit at age 65 with 10 years would be at the IRC §415 maximum for 2004.

Often, advisors confuse Normal Retirement Age with actual retirement age. The former is selected in the Plan Document and provides us a non-discriminatory destination for all participants. It is theoretical, however. Many participants will leave earlier, some will leave later. In all instances, the Present Value of the Accrued Benefit (PVAB) for the 412(e)(3) participant is the cash surrender value of the underlying life and annuity contracts.

Lump Sum Distributions A defined benefit is most often expressed as a non-decreasing benefit at Normal Retirement Age (e.g., 100 percent of pay not to exceed $205,000 at NRA62). However, many participants may desire to receive a Lump Sum benefit instead of a life annuity. This, and other optional forms of benefit can be offered but must satisfy the requirements of IRC §415(b)(2)(E). Although the Present Value of Accrued Benefits of a 412(e)(3) Plan is equal to the Cash Surrender Value, if a Lump Sum Benefit is desired, it must satisfy this Code section as well.




When converting the maximum benefit limitations to an equivalent Lump Sum, the plan’s interest rate and mortality table or table of reduction factors are used. For example, some company’s products are based on a 3.5 percent interest rate with a blended 1971 IAM mortality table. However, this amount cannot exceed the actuarially equivalent amount calculated using the applicable interest rate and the applicable mortality table which currently is GAR 1994. [Rev. Rul. 98-1, Q&A 7, 1998-2 IRB 5] When reviewing this issue, it is important to note that this limitation only applies if the benefit is taken as a Lump Sum. A participant who receives his or her benefit in the form of a life annuity or Qualified Joint and Survivor Annuity (QJSA) will not have this problem.

The applicable interest rate is defined in IRC §417(e)(3), which was added to the Code following the ratification of the General Agreement on Tariffs and Trade (GATT) as enacted in RPA ’94 for plan years beginning after 1994. Thus, the Lump Sum conversion required interest rate is often referred to as the “GATT Rate.”

Lump Sum Limit Example

To better understand this important limitation, let’s compare the maximum

benefits allowable under IRC 415(b)(2)(E) to the 412(e)(3) required accumulation for our participant, age 50 with a $165,000 history that defines the benefit at various Normal Retirement Ages (NRA) :

412(e)(3) 415 Lump

NRA Monthly Benefit

Cash Value Sum Limitation Difference

55 $8,502 $1,703,808 $1,409,950 $293,858

60 $11,934 $2,143,549 $1,810,926 $331,623

62 $13,750 $2,346,416 $2,001,672 $344,960

65 $13,750 $2,155,172 $1,865,672 $289,500

Taking a Lump Sum from a 412(e)(3) Plan As many clients wish to have the flexibility to take a lump sum distribution in lieu of the monthly retirement benefit, what do you do about those whose lump sum exceeds the “GATT” limit? There are four different approaches that may be used: 1. Make an assumption as to what the 30-year Treasury rate will be at the principal’s retirement date. Then use our guaranteed settlement option rate to determine what the equivalent guaranteed annuity amount of the GATT




maximum would be. Use this lower monthly amount in determining the formula for the 412(e)(3) plan. 2. Fund for the maximum monthly benefit, but terminate the 412(e)(3) plan once the maximum lump sum amount is reached. 3. Fund for the maximum monthly benefit, but fund the Plan for only a certain number of years until the maximum lump sum amount is reached based on a projected 30-year Treasury rate. Freeze the Plan and convert it to a classic defined benefit at that time. 4. Fund for the maximum monthly benefit until retirement. Use any excess funds remaining from the Lump Sum benefit to pre-pay retiree medical insurance or, if the Plan continues, to help fund the benefits of other participants [IRC 420]. Using any approach will produce higher initial deductions than a classic defined benefit plan. By funding for the maximum benefit with a goal to take a Lump Sum, the 412(e)(3) election will simply “front-load” the required deductible contribution in the early years. Later contributions may be curtailed and perhaps a defined contribution plan adopted should the 412(e)(3) plan be frozen or terminated.

Case Study Let’s see how the 412(e)(3) plan can front-load the contribution by returning to our 412(e)(3) annuity funding projection. We have compared this to a very simplified defined benefit plan using a constant 5.5 percent investment yield. Returning to our prior case study, the client has selected the maximum annuity-only 412(e)(3) plan to “front-load” the tax-deductible contribution. In year 9, the client then decides to amend the plan to ensure that the GATT limit is not exceeded at his Normal Retirement Age. The plan will no longer be eligible for the 412(e)(3) exemption, thus it will revert to a traditional defined benefit plan, which will be regulated by GATT.

In the following chart we assume the 412(e)(3) annuity continues to earn 3.5 percent. With no future contributions, the values at Normal Retirement Age are very similar to the level-funded plan and should be available as a lump sum if the GATT rate is 5.5 percent or lower.




412(e)(3) “Lump Sum” Planning

Defined Benefit Plan 412(e)(3) Plan

Theoretical Fund Annuity Annuity

Contribution Balance Year Premium Balance

$145,859 $145,859 1 $187,997 $187,997

$145,859 $307,763 2 $187,057 $381,634

$145,859 $478,571 3 $186,089 $581,080

$145,859 $658,773 4 $185,092 $786,509

$145,859 $848,887 5 $184,065 $998,103

$145,859 $1,049,457 6 $183,007 $1,216,042

$145,859 $1,261,059 7 $181,917 $1,440,520

$145,859 $1,484,298 8 $180,794 $1,671,733

$145,859 $1,719,816 9 $72,341 $1,802,584

$145,859 $1,865,675 10 $0 $1,865,675

Benefits Taxation

Retirement Benefits

A participant will be taxed on any distribution received as cash under a retirement plan upon termination or separation from service (IRC §402). The taxable gain from any distribution of the life insurance contracts will be reduced by the cumulative “PS 58” costs previously declared as income. Distributions are taxable when received. However, if a participant wishes to defer taxation, they may simply rollover the 412(e)(3) cash values to an IRA. If they wish to defer taxes on the life insurance policy, the policy and annuity may simply be transferred to a successor profit sharing plan as an “in-kind” contribution. [Rev. Rul. 73-338, 1973-2 CB 20]

Recall that only greater than 5 percent owners need to take Required Minimum Distributions (RMD) at age 70 1/2, even if they are “active” participants in the plan. Thus, if our life insurance policy is held in the profit sharing plan until actual retirement or separation from service, any RMD should be taken from the other plan assets (i.e., former annuity assets).

Life Insurance Taxation

The life insurance policy, however, requires some special treatment if it is

to be maintained. Upon separation from service, or retirement, the life insurance policy used to provide the pre-retirement survivor benefits must be removed from the plan. Unlike the annuity, it cannot be rolled over to an IRA.

Recent IRS Guidance. Recently, the IRS submitted proposed changes to the Code regarding the value of life insurance contracts when distributed from a qualified retirement plan. Specifically, §402(a), 79 and 83 will be amended to




specify that the Fair Market Value of the life policy is the measure of any taxable gain when a policy is distributed to the participant. This taxable event is reduced by the “PS 58” tax basis, if any.

The service provided a safe harbor definition of Fair Market Value that

may be relied upon until final regulations are published.

Survivor Benefits If death occurs prior to retirement, the plan will pay a survivor benefit to the named beneficiaries of the participant. This beneficiary election is filed with the plan Trustee. It should be noted that spouses of the participants have a right of election for most death proceeds unless waived. Often, the annuity contract balance is rolled to an IRA (either decedent or spousal) so that taxes may be deferred or “stretched” at the option of the beneficiary. Life insurance death benefits are treated differently. As the “PS 58” cost was either taxable income (to employees) or not deductible (owners of non-incorporated businesses), the amount of pure insurance will be received free of income tax under §101(a) of the Code. [Treas. Reg. 1.72-16(c)(4)] The cash surrender value of the policy will be taxed as ordinary income if received by the beneficiary. This taxable event is reduced by the “PS 58” cost that was already declared as taxable income (if applicable). [Treas. Reg. 1.72-16(b)]. The remaining death benefit above the cash surrender value is paid to the beneficiary income tax free.

Life Insurance Limits To maximize the available benefits of a 412(e)(3) plan, life insurance will typically be used to enhance the “pre-retirement survivor benefits” offered by the plan. The guaranteed cash values and guaranteed premiums of the whole life insurance contracts are ideal for funding a “fully insured” plan. Life insurance in all qualified retirement plans must comply with the “incidental insurance” rules. These provisions limit the amount of life insurance that may be purchased under the plan. Generally, a defined benefit plan can provide no more than 100 times the projected monthly retirement income as a pre-retirement survivor benefit.

An alternative under Rev. Rul. 74-307 allows up to 66 2/3 of the “theoretical level premium” to be used to purchase life insurance contracts within a defined benefit plan. In practice, this rule translates to less than 50 percent of the first year contribution for most participants but varies by age.




Recent IRS Guidance. As the “product is the Plan,” insurance contract suitability is critical for a compliant 412(e)(3) design. Perhaps because of its nickname “fully insured,” some planners suggested that a Plan could be funded exclusively with life insurance contracts. As discussed in Rev. Rul. 2004-20, this is not allowable. Life insurance must be incidental to the basic purpose of the Plan to provide benefits at retirement.

Rather, the “fully insured” nickname simply describes that an insurance company must guarantee the benefit, which is expressed as a series of equal and periodic payments for the life of the participant. In other words, an annuity or a settlement option of an incidental life insurance contract. Violating the incidental death benefit limit will result in the Plan becoming a listed transaction for the purposes of §1.6011-4(b)(2) and must register as a “Tax Shelter.” As the following chart reveals, the life insurance premium used to fund these survivor benefits may have a fairly modest marginal cost when traditional life insurance products are used, particularly at younger ages. The marginal cost can be calculated by comparing the cost of providing the retirement benefit with an annuity alone vs. the cost of funding the same retirement benefit plus the enhanced survivor benefits.

Stated another way, adding an enhanced survivor benefit to a defined benefit plan does not alter the retirement benefit by one dime. Rather, the marginal cost of the survivor benefit is calculated and is added to the tax-deductible contribution. The marginal cost may be pennies on the dollar at younger ages and is still quite reasonable even for advanced ages.

While life insurance does not need to be offered under a 412(e)(3) plan, it can provide important additional benefits for each participant. If there is an insurance need, the participants may obtain the benefits of life insurance on a pre-tax basis. For highly profitable, closely held businesses, there often exists a substantial insurance need for the owner(s). A “fully insured” plan can both maximize the current contribution, but also can meet these needs by funding the benefit with life insurance contracts.




“PS 58” Cost

When life insurance is included inside a pension plan, the participants must recognize the cost of the “current economic benefit” provided by the plan (IRC §72(m)(3)(B), Reg. §1.72-16(b)). Each participant is taxed currently on the cost of the “pure” life insurance benefit. This then enables the “pure” life insurance benefit to be received by the beneficiary free of income tax. The cost of this current benefit is commonly referred to as “PS 58” cost. That’s because the cost was determined by using the one-year term rates published as Pension Service Table 58 in Rev. Rul. 55-747 (1955-2 CB 228).

Recent IRS Action. Table PS 58 was formally revoked by IRS Notice 2001-10 and a new interim rate was provided as Table 2001. Although IRS Notice 2002-8 modified much of this initial guidance, Table 2001 was retained as an interim measurement of the economic benefit cost for life insurance sold within a qualified or other employer-sponsored plan. An updated table may be published in 2005.

However, if the company’s one-year term rates are lower, the participant

may use these lower published rates for policies issued prior to January 28, 2002. To use alternative term rates after this date, the insurer’s rates must meet added conditions.

Although life insurance may add a small amount of additional taxable income to each participant, the “PS 58” cost becomes “basis” and may be recovered upon distribution of the proceeds for most participants. An exception would be owner-employees of non-incorporated businesses (e.g., a sole proprietor). These individuals do not declare the “PS 58” cost as taxable income. Rather, they simply do not deduct its cost. The end tax result is similar. The client’s tax advisor should be prepared to guide them in accounting for this cost properly.

Life Insurance–Beyond Retirement

The life insurance contracts held by the 412(e)(3) Trust are used to secure the “pre-retirement survivor benefits” of the plan. However, when a participant retires or separates from service with a vested benefit, the life insurance contracts must be removed. [Rev. Rul. 54-51, 1954-1 CB 147] The participant can choose from the following options:

-The contract may be surrendered for its cash value and used to pay the promised benefit. This is the option that is assumed when the 412(e)(3) plan is implemented.




-The plan can sell the contract to the participant or certain Trusts for its cash surrender value. If this value equals the Fair Market Value (FMV), there is no taxable event. However, if the cash surrender value is less than the FMV, the difference will be imputed income to the participant. [PTE 92-6, 57 Fed. Reg. 5189 (1992)] -The policy may be distributed from the plan. The participant is taxed on any gain above the tax basis from any previously declared “PS 58” cost. [Treas. Reg. 1.72-16(b)(4)] -The policy itself may be transferred to a successor defined contribution retirement plan. However, an amount equal to the “PS 58” basis (if any) is returned to the participant and not rolled over. [IRC 402(c)(2)] Some companies offer innovative exchange provisions in addition to these

options. It helps to work with companies that understand this market and have developed products and features to support it. In any event, by exercising one of the many options available, the participant can continue permanent life insurance protection beyond retirement or separation from service.

Recent IRS Guidance. The Service grew concerned about the

nondiscriminatory availability of benefits, rights and features regarding life insurance in qualified plans. In Rev. Rul. 2004-21, they caution that the right of the policy to be sold to the participant must be granted to each participant and should satisfy the prohibited transaction class exemption described by the Department of Labor in PTE 92-6, 57 Fed. Reg. 5189 (1992). This exemption allows for the sale of a policy to the insured, a relative of the insured to the employer or to another Plan and certain trusts. The following conditions must be satisfied:

1. The participant must be the insured; 2. The relative must be the beneficiary of the policy; 3. The plan would surrender the policy if it were not otherwise sold; 4. If the sale is to someone other than the participant, the participant is informed of the sale and given the opportunity to purchase the policy and consents in writing to the sale; and 5. The amount received by the plan for the policy is equal in value to the amount that the plan would have received had it surrendered the policy.

The service also stated that any “bargain element” received by the

purchaser as the result of a sale for less than the Fair Market Value of the policy




would be taxable to the participant. Thus, the sale is allowed to occur at cash surrender value, but if the Fair Market Value is higher, there will be imputed income to the participant.

Administration

To formally adopt a 412(e)(3) plan, certain steps must be taken. These include:

1. Establish the plan in writing prior to the last day of the client’s tax year (execute the Plan Documents).

2. Adopt the plan with a Board of Directors resolution (if applicable). 3. Provide a Summary Plan Description that describes the plan to

participants. 4. Fund the plan by the tax filing date, including extensions (apply for and

fund the individual annuity and life insurance policies).

If life insurance is called for in the plan, applications should be submitted so that an underwriting decision can be made. Recall that substandard ratings may effect plan contributions and benefits.

The owner and beneficiary of each annuity or life insurance policy should be the Plan. Dividends must be applied to reduce the premium.

Annual Service

Each year required contributions for the 412(e)(3) plan must be recalculated and required reporting accomplished. Those are services of a Third Party Administration (TPA) firm. The following is an outline of the process that most TPAs use:

1. Annual Information Request. Each year, the TPA sends a request to the plan sponsor to update census and other important information.

2. Policy Valuation. The TPA will check with the insurance company to

record the value of the annuity and life insurance contracts, determine any excess interest earned or dividends paid.

3. Current Cost Calculated. The cost for the current year’s benefit accruals is calculated by comparing the census and plan data to the policy valuation.

4. Fund the Plan. Once the current cost is calculated, the plan must be

funded by the tax filing date (including extensions).




5. Required Reporting. Each year the plan is required to file an Annual

Return/Report of Employee Benefit Plan (IRS Form 5500 series). A TPA should draft the form for review and execution by the plan sponsor.

Should the goals of the plan sponsor change, the Plan can be amended (or terminated) PRIOR to the accrual of benefits for that year. Most plans will specify that a benefit is accrued after 1,000 hours of actual service is performed by each eligible participant. Furthermore, prior to 2.5 months after the end of a plan year, the projected benefit can be amended to cause a reduction in the required plan contribution, so long as benefits already acceded are not reduced.

Conversions

It is sometimes desirable to convert a classic defined benefit plan to a “fully insured” 412(e)(3) plan. However, this conversion must be accomplished within 30 days of the first day of the plan year. Once converted to 412(e)(3) status, all future benefits will then be guaranteed by insurance contracts. The accrued benefits of the existing defined benefit plan must also be guaranteed by annuity contracts from the same insurer. This is accomplished by converting all the existing plan assets to a Single Premium Deferred Annuity whose guaranteed interest and annuity purchase rates will be used to fund the benefit.

The employer’s deductible limit with respect to the conversion year and

succeeding plan years, other than for any contribution to fund additional top-heavy benefits, is the sum of:

1. The normal cost for a 412(e)(3) plan established on the conversion date

for post-conversion benefit accruals; 2. The limit adjustments, if any, for any ten-year amortization bases

remaining unamortized as of the conversion date that are maintained for purposes of Code Section 404(a)(1)(A)(iii); and

3. The limit adjustment, if any, for any ten-year amortization base created

on account of treating the plan as if terminated for purposes of Code Section 412 as

of the last day of the plan year immediately proceeding the conversion year (pre-conversion year). [Rev. Rul. 94-75, 1994-2 CB 59]

As you can imagine, converting a classic defined benefit plan to a 412(e)(3) requires some rigorous actuarial calculations and should not be approached casually. Most firms will provide this calculation on a fee-for service basis only.




Over-Funded Plans

Due to the record investment returns experienced by many plans in the 1990’s, a number of defined benefit plans are still over-funded. When a plan is over-funded, no contributions may be made. Should an over-funded plan be terminated, a very likely prospect when the small-business owner retires or dies unexpectedly, any excess assets are subject to a 50 percent excise tax in addition to income taxes. By converting to a 412(e)(3) plan, the over-funding problem can be cured in some cases and a current tax deduction restored.

However, some plans may be so severely over-funded that converting to a “fully insured” plan may not immediately solve the problem. By adding a large amount of life insurance as a survivor benefit, should the owner die and the plan terminate, the additional life insurance protection may be more than sufficient to restore the values lost to excise and additional income taxes.

Another option is to find a company that specializes in rescuing over-

funded defined benefit plans. These specialty companies find other defined benefit plans that are significantly under-funded and through the purchase of both plans, both parties are able to benefit by each other’s misery.

Under-Funded Plans

Due to wide swings in the market of the past few years, some defined

benefit plans are now under-funded, or plan costs have become less predictable. Some sponsors may be concerned about the added liability (and PBGC costs) associated with an under-funded plan. By converting to a 412(e)(3) plan, the uncertainty can be removed and all plan benefits guaranteed.

As future benefits may have a higher initial cost, the plan may be amended (reduced) to keep future employer costs reasonable. Past benefits are protected; they can’t be reduced. As the past benefits must now be guaranteed by the insurance company, it is likely that a conversion to a 412(e)(3) plan will require a substantial financial commitment. This very large contribution is required to be made within the first 30 days of the plan year and must be made. A client should therefore be very careful when converting a severely under-funded classic defined benefit plan to a 412(e)(3).

Plan Funding

Should a defined benefit fail to comply with IRC 412(e)(3), it is not automatically disqualified. It may be amended into a regular defined benefit plan under § 430. Due to the large contribution and conservative assumptions, conversion will most likely result in the plan becoming over-funded, at least for several years.




One technique that some businesses will use is to adopt a “fully insured” plan while the owner is earning a very high income. The retirement definition may be selected to recognize the “best” three consecutive year period of average income. If the preferred participant’s income is expected to decrease, as he or she gets older, at some point (usually after five years) the “fully insured” plan is converted to a “fully funded” defined benefit plan. Contributions may be eliminated or greatly reduced using this approach, ensuring maximum current contributions in the highest income years and lower or no contributions as the owner approaches retirement and is perhaps working fewer hours. This flexibility is a significant advantage of the 412(e)(3) plan for particular situations.

412(e)(3) Abuses

Why “Out-of-the-Normal” Funding in a 412(e)(3) Plan Seemed Like a Good Idea If a client contributed $250,000 into a 412(e)(3) Plan each year for five years as a tax deductible expense, he/she would have funded $1.25 million dollars over that five-year period. If we assumed the entire $250,000 went into life insurance as an investment in the 412(e)(3) Plan, the cash surrender value (CSV) of the policy at the end of the fifth year would be approximately $250,000. The client (key employee/owner) would then be counseled to purchase the life policy from the 412(e)(3) Plan for that $250,000 cash surrender value. When that happens, the client feels like he/she got a great deal because the cash account value (CAV) of the policy was really $1,100,000. The physician then waits for the surrender charges in the life policy to dissipate and takes “income tax free” loans from the policy in retirement. Buying a policy with a low CSV but a high CAV seems like a steal of a deal since the client only paid 1/5th of the value of the asset when purchasing it out of the 412(e)(3) Plan. This concept is supposed to save the client 80% of the tax on that money. Sounds good? Well, it did to many client and advisors looking to sell large life insurance policies who sold thousands of these plans nationally. The IRS was watching the evolution of these abusive 412(e)(3) plans on Friday the 13th , issued three Revenue Ruling in an attempt to curb the use of these plans. Summary of the Regulations and Revenue Rulings Rev. Proc. 2004-16 Rev. Proc. 2004-16 basically states that the “fair market value” of a life insurance policy coming out of a 412(e)(3) DB Plan should be the premiums paid not the cash surrender value or internal reserve value of the insurance company.




How would this affect a 412(e)(3) plan that was recently implemented? If sustained by a tax court, the client who planned on purchasing the life policy from the 412(e)(3) Plan in Year Five would have to use as the value not the cash surrender value (which is 80% lower than the premiums paid) but instead the premiums that were paid as the value (minus minor term costs). This outcome would destroy the tax favorable nature of a 412(e)(3) Plan with the five-pay life policy and, therefore, the client would have been much much better off by paying tax on their money and investing it post-tax in the stock market. Like a lot of Rev. Ruling and Regulations on “advanced” tax topics, the IRS does not always know how to give guidance on what should be done but instead just tries to muddy the waters and scare clients so that the tax topics are not used due to uncertainty about the law. The IRS seemed to have accomplished its goal of throwing cold water on the use of the abusive 5-pay policies (although it is amazing the some advisors still sell this concept to their clients). Rev. Ruling 2004-20 Rev. Ruling 2004-20 relates that the IRS does not want ““excess”” life insurance purchased inside a 412(e)(3) Plan specifically (i.e., insurance contracts where the death benefits exceed the death benefits provided to the employee’s beneficiaries under the terms of the plan, with the balance of the proceeds reverting to the plan as a return on investment).

This Rev. Ruling basically states that, if ““excess”” death benefits are purchased, those deductions will be disallowed in the current year and will be spread out, if allowable, over future years of the plan. Further and very punishing is that any non- deductible premiums will be subject to a 10% excise tax.

Lastly, the IRS in an effort to throw more cold water on the subject has added non-compliant 412(e)(3) Plans with springing cash value policies to the listed transaction list (which carries with it very negative tax ramifications for the client).

Rev. Ruling 2004-21 This Rev. Ruling basically says that a qualified plan cannot discriminate in favor of highly compensated employees by buying life policies for the non-highly compensated employee that are not ““inherently”” equal.

The word ““inherently”” indicates again to me that the IRS does not know how to define certain standards or rules when trying to give final guidance to the taxpayer.




It is anticipated that sometime in 2005 (potentially 2006) new IRS regulations will be passed that will give clear (if that’s possible from the IRS) guidance as to how springing cash value policies will be valued when purchased or distributed from a qualified plan.

Abusive Tax Shelter?

412(e)(3) plans with the use of a “springing” cash value life insurance policy is now on the listed tax transaction list. For a further explanation of how the listed tax transaction rules work and how negatively the rules can affect the client and the client’s advisor(s), please read the educational module on VEBAs/419A(f)(6) Plans. Life insurance when purchased in the proper manner inside a 412(e)(3) plan should not have problems with the above Rev. Ruling or be seen as an abusive tax shelter.

Summary on 412(e)(3) Plans

A 412(e)(3) plan is fairly simple and maybe the ideal plan for the owner of a small business or professional enterprise that desires to maximize his or her current tax deduction and secure guaranteed retirement income. The contributions are, by design, quite large in the early years of the plan and may be less appealing as the number of plan participants increases.

Unlike a classic defined benefit plan, a 412(e)(3) plan holds its Trust assets in annuity or a combination of annuity and incidental life insurance policies. The funding model presumes that only the contractual guarantees will be paid. Excess annuity interest and whole life dividends simply reduce future plan contributions.

Introducing life insurance to fund a portion of the retirement benefit will provide increased initial contributions and an additional pre-retirement survivor benefit for each participant. Existing plans may benefit by converting to a “fully insured” design providing substantially higher current benefits and reduced exposure to excise taxes.

Summary on Qualified Retirement Plans As you can tell from this material, qualified retirement plans (QRP) can be very rewarding and helpful to clients. The material also illustrates while there are several options clients can consider when funding a QRP, those options can sometime be confusing or complicated. In order to help clients with QRPs, advisors do not have to be an actuary or a pension plan expert. Advisors simply need a good working knowledge of all the available options and a third party administrator that knows their stuff and will provide unbiased advice to your clients.




Advisors who have clients that make a sizable annual income and are not helping those clients make sure they have the “right” QRP are doing their clients a disservice. Hopefully this material has been helpful in explaining the various QRP options (and their pros and cons) and will help advisors grow their business by being able to provide competent advice to their clients on this topic.

401(h) Post-retirement Medical Benefit Option Tax Deductible, Tax Sheltered and Tax Free Payouts The 401(h) post retirement medical option is perhaps the most overlooked and underutilized plan benefit. The 401(h) benefit can add upto 33.33% to the otherwise maximum tax deductible contribution of your client’s pension plan. All earnings are tax sheltered and payouts are tax free under either IRC Sec 105 or 106. The planning impact is obvious, as is the competitive advantage it gives the serious planner with respect to any planning competition. 401(h) options do not vest conventionally. A plan participant otherwise vesting in retirement benefits must retire in the employee of the plan sponsor in order to receive the 401(h) benefit. Any plan participant leaving prior to retirement forfeits 100% of the 401(h) plan benefit. Hello “Golden Handcuffs”, that really work! 401(h) FAQ Addendum What is a medical expense account under Code Section 401(h)? A medical expense account under Code Section 401(h) is an account within a defined benefit pension plan for the payment of the sickness, accident, hospitalization, and medical expenses of retired employees and the spouses and dependents of retired employees. [Treas. Reg. §1.401-14(a)] The term retired for purposes of eligibility to receive medical benefits under Code Section 401(h) means that the employee is eligible to receive retirement benefits under the plan or is treated as retired by the employer by reason of the employee's permanent disability. An employee who must terminate employment with the employer as a condition of receiving retirement benefits is not considered retired. [Treas. Reg. §1.401-14(b)(1)] What requirements must a plan satisfy with respect to a Section 401(h) arrangement?




A plan must satisfy the following requirements with respect to a Section 401(h) arrangement: Nondiscrimination. A Section 401(h) arrangement cannot discriminate in favor of officers, shareholders, supervisory employees, or HCEs with respect to coverage or with respect to contributions and benefits. The determination of whether a Section 401(h) arrangement so discriminates is made with reference to the retirement portion of the defined benefit plan as well as the Section 401(h) arrangement. [Treas. Reg. §1.401-14(b)(2)] Benefits. A Section 401(h) arrangement must specify the medical benefits that will be available and must contain provisions for determining the amount that will be paid. Furthermore, such benefits, when added to any life insurance protection provided under the defined benefit plan, must be subordinate to the retirement benefits provided by the plan. [Treas. Reg. §1.401-14(c)(1)] Separate account. A separate account must be established for the contributions used to fund the Section 401(h) benefits. The separation is for recordkeeping purposes only; therefore, the plan can invest the contributions to the 401(h) account in the same manner as it invests funds used to provide retirement benefits. [Treas. Reg. §1.401-14(c)(2)] Reasonable and ascertainable contributions. The contributions to fund medical benefits must be reasonable and ascertainable. The employer must, at the time it makes a contribution, designate the portion of the contribution allocable to funding medical benefits. [Treas. Reg. §1.401-14(c)(3)] Impossibility of diversion prior to satisfaction of all liabilities. It must be impossible at any time prior to the satisfaction of all liabilities under the plan for any part of the corpus or income of the medical benefits account to be used for, or diverted to, any purpose other than providing medical benefits under the plan. The payment of necessary or appropriate expenses attributable to the administration of the medical benefits account, however, does not affect the qualification of the plan. [Treas. Reg. §1.401-14(c)(4)] Reversion on satisfaction of all liabilities. The plan must provide that any amounts that are contributed to fund the 401(h) account and that remain in the account after satisfaction of all liabilities arising out of the operation of the Section 401(h) arrangement are returned to the employer. [Treas. Reg. §1.401-14(c)(5)] Forfeiture. The plan must expressly provide that if an individual's interest in the medical benefits account is forfeited prior to termination of the plan, an amount equal to the amount of the forfeiture will be applied as soon as administratively possible to reduce employer contributions to fund the 401(h) account. [Treas. Reg. §1.401-14(c)(6)]




When are benefits provided under a Section 401(h) arrangement considered subordinate to retirement benefits? The medical benefits provided under a Section 401(h) arrangement are considered subordinate to the plan's retirement benefits if at all times the aggregate contributions made to provide the medical benefits and any life insurance protection do not exceed 25 percent of the aggregate contributions (made after the date that the plan first includes the medical benefits) exclusive of contributions to fund past-service credits. [Treas. Reg. §1.401-14(c)(1)(i)] Example:

The Landscaping and Rock Company amended its defined benefit pension plan to provide medical benefits as described in Code Section 401(h) effective for the 2000 plan year. The total contributions under the plan (excluding those for past-service credits) for the 2000 plan year are

$125,000, of which $100,000 is for retirement benefits, $10,000 for life insurance, and $15,000 for medical benefits. The medical benefits described in Code Section 401(h) are considered subordinate to the retirement benefits because the portion of the contributions allocated to the medical benefits ($15,000) and to life insurance ($10,000), or $25,000, does not exceed 25 percent of $125,000.

For the 2001 plan year, the company contributes $140,000 (exclusive of past-service credits), of which $100,000 is for retirement benefits, $10,000 for life insurance protection, and $30,000 for medical benefits. The medical benefits described in Code Section 401(h) are still considered subordinate to the retirement benefits because the aggregate contributions allocated to the medical benefits ($45,000) and to life insurance ($20,000), or $65,000, do not exceed 25 percent of $265,000, the aggregate contributions made in 2000 and 2001.

Can excess assets in a defined benefit plan be used to fund medical benefits described in Code Section 401(h)? Yes. Employers are permitted to transfer excess assets from a defined benefit plan to an account for the payment of medical benefits described in Code Section 401(h). A plan is deemed to have excess assets for this purpose if assets exceed 125 percent of the plan's current liability. In addition, there are several rules that must be followed:

1. The transferred amount can be used to pay medical benefits for either the year of the transfer or the year of transfer and the future transfer period, called a qualified future transfer.




2. The transferred amount must approximate the amount of medical expenses anticipated for the year of transfer or the year of transfer and future years during the transfer period.

3. An employer can make only one such transfer in a year.

4. All accrued benefits of participants in the defined benefit plan must be fully vested.

5. The employer must commit to a "maintenance of effort" requirement with respect to the medical benefits.

[I.R.C. §420]

This provision that allows for the transfer of excess assets to a 401(h) account is set to expire on December 31, 2013. [I.R.C. §420(b), as amended by the Pension Funding Equity Act of 2004]

For plan year beginning after December 31, 2006, multiemployer plans may also transfer excess pension assets to 401(h) accounts, subject to the same rules as single employer plans. [I.R.C. §420(e)(5)]

How are the excess assets determined? The term excess pension assets means the excess (if any) of --

(A) the lesser of --

(i) the fair market value of the plan's assets (reduced by the prefunding balance and funding standard carryover balance determined under Code Section 430(f)), or

(ii) the value of plan assets as determined under Code Section 430(g)(3) after reduction under Code Section 430(f), over

(B) 125 percent of the sum of the funding target and the target normal cost determined under Code Section 430 for such plan year.

[I.R.C. §420(e)(2)(B)] What is a qualified future transfer?

In lieu of a regular qualified transfer during a tax year, an employer may elect to make a qualified future transfer. A qualified future transfer is equal to the sum of:




1. If the transfer period includes the taxable year of the transfer, the amount determined under a regular qualified transfer (as determined under Code Section 420(b)(3)) for such taxable year; and

2. In the case of all other taxable years in the transfer period, the sum of the qualified current retiree health liabilities which the plan reasonably estimates (to be determined in accordance with guidance yet to be issued) will be incurred for each of such years.

[I.R.C. §420(f)(2)(C)]

The qualified future transfer may transfer excess pension assets from the defined benefit plan to the 401(h) account based on the plan being funded with assets equal to at least 120 percent of current liability rather than a 125 percent of current liability level as required for regular qualified transfers.

[I.R.C. §420(f)(2)(B)(i)] However, the sponsor must also track the funded status of the defined benefit plan during the transfer period and if the current liability ever drops below the 120 percent funded level as of any valuation date during the transfer period, then the employer must either (1) contribute additional funds to the defined benefit plan in order to increase the assets above the 120 percent of current liability, or (2) transfer funds back to the defined benefit plan from the 401(h) account. [I.R.C. §420(f)(2)(B)(ii)] Except as stated above, a qualified future transfer must meet all the other requirements applicable to regular qualified transfers.

What is a transfer period?

The transfer period means, with respect to any transfer, a period of consecutive taxable years (not less than two) specified in the qualified future transfer election which begins and ends during the 10-taxable-year period beginning with the taxable year of the transfer.




Sample List

401(h) Benefits

Pension Benefit Plan & Trust

Below is a sample list of post-retirement medical benefits that may be provided under a

Benefits are not limited to those contained in this list.

Acupuncture Hospitalization Insurance ADD Counseling and Assistance Hospital Bills Air Lift Transportation (Both US and Non US) Insulin Alcoholism Laboratory Fees Alternative Healthcare Laetrile by Prescription Alternative Medicines Lasik Eye Surgery Ambulance Hire Lead Base Paid Removal-Children Artificial Limbs with Lead Poisoning Artificial Teeth Retirement Home for Medical Care Assisted Living Facilities Long Term Care, Nursing Homes Asthma and Allergy Prevention and Treatment Medical Information Plan Birth Control Pills Medicines Braces Membership Fees for Medical Services, Braille-Books and Magazines Hospitalization, Clinical Care, Health Chiropractors Maintenance, Health club memberships Christian Science Practioners’ Fees Nurses Fees, Nurses Room and Board Contact Lenses Including Examination Fee Social Security Tax (Where Paid by Taxpayer) Co-Pays Obstetrical Expenses Cosmetic Surgery (Even Though not Operations (100% of All Costs) by a Physician) Orthopedic Shoes Cost for Care Outside the United States Oxygen Cost of Operations and Related Treatments Personal Trainers Counseling Physical Therapy Crutches Physician Fees Deductibles Premiums for LTC Dental Cosmetic Surgery Preventive Care including but not limited to Dental Fees Spa Facilities, Usage Fees for Facilities Dentures Prosthetics Dependent Care Psychiatric Care Dermatologist Care Psychologist Fees Diagnostic Fees "Seeing-eye" Dog and its Upkeep Drugs Specialists and Specialized Treatments Electrolysis Specially Equipped Cars Experimental Care Special Care Costs for Disabled Dependents Eyeglasses, Including Examination Fee, Special Diets Laser Surgery for Vision Correction Sterilization Fees Fees of Practical Nurse Support Groups Fees for Healing Services Surgical Fees Fees of Chiropractors Therapy Treatments Fees for Fitness Programs and Facilities Transportation Expenses for Medical Services Fees of Licensed Osteopaths including Preventative Care Group Therapy Tuition Fee (part), if College or Private School Handicap Persons’ Special Schools Furnishes Breakdown of Medical Charges Flu Shots Tuition at Special School for Handicapped Hair Transplants Viagra Health Insurance Premiums Vitamins Hearing Devices and Batteries Wheelchair Holistic Care Weight Loss Programs Hospice Wigs

In Home Care X-rays
