412(e)3

412(e)3 with 50% funding to life insurance vs 401(k) Profit Sharing Plan & regular Defined Benefit Plan

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When retirement planning, there are multiple plans that an employer can select. While implementing a 412(e)3 plan does have some benefits, it is important for business owners to maximize their benefits and to be aware of sales tactics that financial advisors will use when trying to push certain plans. The following compares the 412(e)3 Defined Benefit Plan (with and without 50% life insurance), 401(k) Profit Sharing Plan & regular Defined Benefit Plan.

Life Insurance Bought in Defined Benefit Plans


Let us make the assumption that there is $125,000 to be invested. This amount will be allowed to grow for a period of 20 years and at the end of this time, the investments, A and B, will have balances that equal:
Investment 1: $175,000
Investment 2: 350,000
Of course, the second investment option is better since the account balance would be $100,000 greater that the other option.
This question is important to small to medium sized business owners who are trying to find a legal and beneficial method to find large deductions into a plan that can be for the benefit of them in retirement.

Buying Life Insurance in a Plan that is Qualified

What is the 412(e)3 Defined Benefit Plans

This particular plan is a qualified plan for retirement that legally is required to be funded with life insurance annuities. When using the 412(e)3 plan, employers will fund the plan with the goal of providing a retirement income for any employee when they reach a certain age. In addition, these benefits will be based on growth rates that are presumed. If the growth rate is presumed to be low, the employer will have to contribute a higher amount to the plan. Employers will also have to contribute more if employees are close to the specified retirement age. The lower the presumed growth rate the more the business may deduct because more money can be contributed to the 412(e)3 defined benefit plan.

Comparing the 401(k)/Profit Sharing Plan to the 412(e)3 Plan:

When 401(k)/Profit Sharing Plans are being used, employer and employee (both or either) contributions will go towards the plan. The amount in the 401(k) plan can grow and there is no limit to the growth amount. The money that is in the plan can later be withdrawn by any employee that is vested.
However, with the 412(e)3 plans, if the actual return goes beyond the presumed rate of return, all contributions being made by the employer would be reduced but the amount of the retirement income would always remain the same. In other words, the 412(e)3 plan has a guaranteed income.

412(e)3 Plans Benefit:

In the eyes of business owners, these are great plans because the 412(e)3 plans permits the greatest corporate deductions into a qualified plan that benefits the business owner.
Returning to the question that was first asked, would investment 1 or 2 be best? Below is sales advice by many advisors geared towards a doctor, trying to get the doctor to buy into a 412(e)3 plan. The doctor is 57 years of age and earns a take-home pay of $650,000 annually. The doctor desires a large qualified plan contribution. In addition to this information, we will make the assumption that the doctor also has a life insurance policy that is within an irrevocable trust worth $2,000,000.
The financial advisor will offer these options to the owner (i.e. doctor) which illustrates the deductions on a 401(k)/Profit Sharing Plan, a regular Defined Benefit Plan, a 412(e)3 Defined Benefit Plan and a 412(e)3 Defined Benefit Plan with 50% of contributions to a life insurance:
401(k)/PSP $50,000
Regular DB Plan $158,000
412(e)3 DB Plan $254,000
412(e)3 DB Plan with 50% life insurance $324,000
The owner/doctor chooses the 412(e)3 Defined Benefit Plan with 50% contributions to a life insurance because it allows $324,000 maximum contributions and, therefore, the maximum tax deductions.
So is this the best investment plan for retirement? What the financial advisor failed to inform the owner is that the fact of what the retirement income will be for each of the plans. The fact is that the retirement income and benefits will be the same for all the above Defined Benefit Plans.
Many will think that because the 412(e)3 Defined Benefit Plan allows $166,000 more contributions than with a regular Defined Benefit Plan that the retirement income would be greater. However, the truth is that there is a set limit to the amount the owner can accrue. In other words, it doesn’t matter how much the owner contributes, the retirement income will not change.

Increased Tax Deductions with Life Insurance Bought in the 412(e)3 Plan at a High Cost

It is a bit complicated but a life insurance policy helps create a larger deduction because of the formula when loads are factored in causing the assumed rate of returns to plummet and the required contributions to increase. The end result is higher contributions and, thus, higher tax deductions for the business owner.

So what’s the best retirement plan for maximum contributions and maximum retirement income?

The owner will then most likely choose the regular Defined Benefit Plan as this will permit $166,000 in extra cash to be used for other company purchases.
The moral is that many financial advisors will try and sell the 412(e)3 plan inappropriately. The insurance companies actually condone these sales pitches. An advisor is looking for the largest deduction and their main concern is getting 50% of the contributions to the 412(e)3 Defined Benefit Plan to trickle into various life insurance policies. This allows the advisor to receive the highest amount of commission.

When is it a good investment for buying life insurance in a 412(e)3 plan or another qualified plan?

Life insurance should be purchased in a 412(e)3 plan or another qualified plan when the owner or individual does not have any estate tax issues. Should a client have estate-tax problems, there will most likely be estate taxes to deal with when the client dies. This creates even more problems because there will be additional taxes for the death benefit.

Are there any possible difficulties that will arise when purchasing life insurance in a qualified plan?

You would have to answer this question first: When the client reaches the age of retirement and wishes to retire, what happens to the policy? Rolling it over into an IRA is not an option. Instead, the life insurance policy would be distributed to the employee. It would later be gifted to an ILIT (irrevocable life insurance trust). It is also possible for the ILIT to buy the life insurance policy, but this could get very pricey and would require much planning and time.
The bottom line is that advisors should sell 412(e)3 plans based on the retirement benefit and income instead of focusing on the amount of the deduction. If you are a small business owner, you need to know the right questions to ask.
Please contact Estate Street Partners if you wish for assistance on implementing a 412(e)3 plan, a regular Defined Benefit Plan or any other retirement plan to maximize your returns and reduce your taxes.
Category: Insurance

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